ECN FINAL

Fiscal Policy

Any shifts in government spending and taxation decisions fall under the umbrella of _____ .

• These policies are implemented by various fiscal authorities, such as the Treasury in the US or the Ministry of Finance in Canada, with the aim of stabilizing the economy.

Two primary types of fiscal policy

• Active or discretionary policy

• Non-discretionary or passive policy

Active or Discretionary Policy (Two primary types of fiscal policy)

These are deliberate actions taken through parliamentary channels to influence economic conditions.

Non-Discretionary or passive policy (Two primary types of fiscal policy)

These policies occur automatically, without direct intervention from the government.

The Problem of Timing (Policy Effectiveness)

There's often a lag between the onset of a business cycle and the implementation of active policies.

• It takes time for the issue to be identified, for policies to be drafted and passed into law, and for their effects to materialize.

Political Considerations (Policy Effectiveness)

Political dynamics can significantly influence policy decisions. For instance, addressing an inflationary expansion might necessitate unpopular measures such as tax increases.

• Politicians, especially in election years, may hesitate to support such measures due to potential backlash from voters.

Future Policy Reversals (Policy Effectiveness)

If people anticipate future policy reversals, the effectiveness of fiscal policy can diminish.

• For example, if individuals anticipate that a current tax cut will be followed by a tax increase in the future, they may not increase their spending as much as policymakers intend.

Offsetting Provincial and Municipal Finance (Policy Effectiveness)

Provincial governments often adopt pro-cyclical fiscal policies for budgetary reasons.

• When the economy is performing well, provincial governments tend to increase spending, contrary to the counter-cyclical policies advocated at the federal level.

• This behaviour can counteract the effects of federal policies.

Crowding Out Effect

Let’s consider borrowing first:

• When the government borrows money, we expect the demand for money in the economy to rise.

• Assuming the central bank maintains the total money supply constant, the increased demand for money leads to a rise in its value, resulting in higher interest rates.

• Higher interest rates decrease businesses’ incentive to invest, leading to a reduction in spending.

• In economic terms, this phenomenon is known as the ________, where increased government spending crowds out private investment.

Shocks Originating from Abroad (Fiscal Policy in the Open economy)

Other countries also experience economic shocks that can impact the Canadian economy through changes in net exports.

• For instance, if the Canadian government implements an expansionary policy during a recession, but the US economy simultaneously experiences an expansion, the increase in US income could boost demand for imports from Canada.

• This surge in demand for Canadian exports would lead to an increase in AD in Canada, potentially exceeding the intended target of the fiscal policy.

• Consequently, this could result in an unintended inflationary expansion.

Net Export Effect (Fiscal Policy in the Open economy)

Another significant factor is the impact of fiscal policy on international financial flows and exchange rates.

• For example, suppose an expansionary policy in Canada results in increased borrowing and higher interest rates.

• This could attract foreign investors seeking better returns on their investments, prompting them to bring their financial assets into Canada.

• Consequently, they would need to exchange their currency for Canadian dollars (CAD), leading to an appreciation of CAD against other currencies.

• As CAD appreciates, Canadian exports become relatively more expensive for foreign buyers, causing a decline in net exports.

• This decrease in net exports offsets some of the initial expansion in AD generated by the fiscal policy.

National Debt

A budget deficit occurs when a government’s annual spending surpasses its revenue, leading to a _______, which is the aggregate of past deficits minus surpluses.

What does initial equilibrium at GDP₁ and P₁ represent? (Expansionary Fiscal Policy)

What happens if investment spending falls (Expansionary Fiscal Policy)

If AD shifts left during a demand-driven recession what happens? (Expansionary Fiscal Policy)

If AD falls by x, why does GDP fall by x? (Expansionary Fiscal Policy)

Because x represents the total/eventual AD shift after the multiplier effect has already occurred.

• ΔAD = -x → ΔGDP = -x

What is the gap between GDP₁ and GDP₂ (Expansionary Fiscal Policy)

The recessionary gap: the amount by which actual GDP is below potential/full-employment GDP.

• Recessionary gap = GDP_potential - GDP_actual

What is the purpose of expansionary fiscal policy during a recession?

To increase aggregate demand and bring GDP back toward potential GDP.

What are the two main expansionary fiscal policies?

1. Increase government spending

2. Decrease taxes

Both increase aggregate demand.

What is the government spending multiplier? (Expansionary Fiscal Policy)

1/(1-MPC) = 1/MPS

How much must government spending increase? (Expansionary Fiscal Policy)

ΔG = Required Increase in GDP/ Government Spending Multiplier

Tax Multiplier (Expansionary Fiscal Policy)

Is smaller than the government spending multiplier because people do not spend all of a tax cut.

• Formula is - (MPC/1 - MPC)

• Negative sign exists because taxes going down means AD goes up

Example of identifying how much to increase government spending by using multiplier ? (Expansionary Fiscal Policy)

Suppose Recessionary gap is 52 billion and MPC = 0.75

1. Find Multiplier which is 1/1-0.75 = 4

2. Required increase in government spending = 52/4 = 13 billion

Example of identifying how much to cut taxes by using tax multiplier ? (Expansionary Fiscal Policy)

Suppose Recessionary gap is 52 billion and MPC = 0.75

• Tax Multiplier = - (0.75/0.25) = -3

• -(0.75/0.25) TREAT 3 as ABSOLUTE TAXES ALWAYS DECREASE

• 52/3 = 17.33

Overall chain of Expansionary Fiscal Policy

Recession —> AD going down ——> GDP going down and results in recessionary gap

What is the effect of an increase in government spending G? (Expansionary Fiscal Policy)

G goes up —→ AD goes up ———→ GDP goes up

If government spending increases by y, what is the initial shift in AD?(Expansionary Fiscal Policy)

ΔG=y

• The initial shift in AD is also y.

Why does an initial increase in government spending create further increases in AD? (Expansionary Fiscal Policy)

The government's spending becomes someone's income. That person spends their MPC, creating income for someone else, who spends again.

• Government spending ——→ Income ——→ Consumption ——→ More Income ——→

What does it mean when tax multiplier is smaller than the government spending multiplier because people do not spend all of a tax cut…. (Expansionary Fiscal Policy)

Suppose the government increases spending by $100, that entire $100 immediately becomes spending in the economy.

• Suppose the government cuts taxes by $100, people now have $100 and have more disposable income, but if MPC = 0.75, they spend only $75.

• Therefore, initial increase in AD is only $75 not $100

Contractionary Fiscal Policy

It is only logical to think that, whenever there is an inflationary output gap in the economy, policymakers can use a similar strategy to combat the inflationary expansion, but in the reverse direction.

• Such a policy is called a ____ : the objective of this policy is to contract output, thereby mitigating inflationary pressures.

It’s important to note that while the increase in aggregate demand may initially boost output… (Contractionary Fiscal Policy)

A portion of this increase is absorbed by rising prices.

• Consequently, the actual increase in output (reflected by the distance between GDP₁ and GDP₂) is less than the total shift in aggregate demand (y<x).

• In essence, the economy experiences both inflationary pressures and a positive expansion in output.

How can fiscal policy be used to address an inflationary output gap?

One approach is for the government to reduce its spending, which would shift the Aggregate Demand (AD) curve back to its original position.

• But how much should the government cut its spending by?

What happens when AD shifts right?

AD↑→GDP↑ and P↑

The economy experiences:

• Higher output

• Higher prices

• Inflationary pressure

What does y represent (What is the inflationary output gap?)

The amount by which GDP is above potential/full-employment GDP.

• = GDP_actual - GDP_potential

What does X represent? (Contractionary Fiscal Policy)

Total initial shift in the AD to the right

• The original AD increase is _

• However, not all of that increase becomes additional output

• Some of the increase is absorbed by higher prices

• Therefore Y < X

Why is the increase in output smaller than the increase in AD? (Contractual Fiscal Policy)

Because when AD increases, some of the effect causes:

• Prices↑

and only the remaining effect increases real output.

• So: X = price increase effect + output increase y

• Therefore y < x

What happens when government spending decreases?

G↓→AD↓→GDP↓

• This is contractionary fiscal policy.

Why not simply cut government spending by 0.25x? (Contractionary Spending Decreases?)

Suppose MPC = 0.75, which means Multiplier is 4.

• One may think ΔG=4x​=0.25x, because 0.25x x 4 = x

• This would reduce AD by the entire x, which is too much

• This is because economy only needs output to fall by y, and not by x

What is the required reduction in government spending? (Contractionary Fiscal Policy)

The government wants AD to fall by y

• The government spending multiplier is 1/1 - MPC

• Therefore, ΔG = y/Multiplier

• If MPC = 0.75, then Multiplier = 4

• So ΔG = y/4 = 0.25y

• The government should reduce 0.25y

Why does reducing by 0.25y work? (Contractionary Fiscal Policy)

The multiplier effect magnifies the initial reduction:

• 0.25y x 4 = y

• Therefore AD goes down by y

• Since the AS curve is flat, when AD shifts left due to downward price stickiness, GDP goes down by Y

• This closes the inflationary output gap exactly

What happens when taxes increase?

• Disposable income goes down

• Consumption goes down

• AD goes down

• GDP goes down

• This is also contractionary fiscal policy

How does the size of government influence the choice between taxes and government spending?

If the government is already large, policymakers may prefer using tax cuts during a recession rather than increasing government spending.

• If the government is relatively small, policymakers may prefer increasing government spending.

During a recession, if the government is already considered too large, what expansionary policy may be preferred?

Taxes going down

• A tax cut increases disposable income

• Consumption goes up

• AD goes up

• GDP goes up

During an inflationary expansion, if the government is already large, what contractionary policy may be preferred?

Government spending going down

• This reduces AD and GDP without increasing taxes.

How does tax multiplier work with contractionary fiscal policy?

If MPC is 0.75, then tax increase of z —→ 3z decrease in AD

How much does taxes increase (Contractiionary fiscal policy)

The government wants AD to decrease by y

• ΔT = y/Multiplier

• With ΔT = y/3 if MPC = 0.75

Complete Contractionary Fiscal Policy Chain

AD goes up by x

• This creates GDP goes up by y

• Where y < x, because some of the AD increase caused prices to rise.

What if the government is relatively small during a recession?

Government spending increase may be preferred

What if the government is relatively small during a inflationary expansion?

Tax increase may be preferred

What are the main sources and uses of government money?

• Revenue: Taxes

• Expenses: Government Spending

What is a government surplus?

Occurs when

• Government revenue > Government spending

• T > G

What is government deficit

Government spending > Government revenue

• G > T

Government surplus formula

T - G

What happens to the government budget during a recession?

Expansionary fiscal policy means Government spending increasing or Taxes decreasing

• Both reduce the government surplus or increase the deficit

Why does increasing government spending create a deficit

When G goes up while tax revenue has no increased

• Using Surplus = T - G

• If G increases, then it takes up more revenue (taxes)

What happens to the government budget during an expansion?

Contractionary fiscal policy means: G goes down and T goes up

• Both increase the government surplus or decrease the deficit

What is active/discretionary fiscal policy

Deliberate changes in government spending or taxation that require government action and usually legislative approval.

What is passive/non-discretionary fiscal policy?

Fiscal changes that happen automatically as economic conditions change, without the government passing new legislation.

What is an automatic stabilizer

A feature of the economy or tax system that automatically reduces economic fluctuations.

• Key example is Progressive tax system

What happens to tax rates as income increases?

Generally, higher-income earners pay a higher percentage of their income in taxes.

• Income goes up and Tax rate Goes up

Why do progressive taxes automatically stabilize the economy>

• Income increases, then Tax Revenue Increases

• Income decreases, then Tax Revenue decreases

What happens to income during a recession?

People may earn less because of

• Job losses

• Reduced Hours

• Lower business profits

What happens to tax revenue in a recession?

Income decreases, then tax revenue decreases

• this happens automatically

How does this help stabilize the economy

When income falls, people automatically pay less tax

• Therefore, disposable income falls less than it otherwise would

• This helps support C

What happens to the government budget during a recession?

• Because tax revenue falls: Surplus goes down

• Or Deficit goes up

• Happens automatically

What happens to income during an expansion?

Income goes up

What happens to tax revenue during an expansion?

Income goes up, and tax revenue goes p

How does progressive tax help stabilize an expansion

Higher taxes reduce the growth of disposable income

• Therefore disposbale income grows less

• This limits the growth of C

• Therefore limits AD

Recognition Lag

“Do we realize there is a problem?”

• The government needs time to recognize that the economy is entering a recession or experiencing inflation.

Administrative Lag

“Can we get the policy approved?”

• Once politicians recognize the problem, they need to debate, negotiate, and pass legislation.

Operational Lag

“How long until the policy actually works?”

• The policy has been approved, but it takes time to implement and produce an economic effect.