Week 8 POE Fiscal Policy

covers fiscal policy

Fiscal Policy Definition

Decisions government makes about spending, borrowing, and taxes in the short run

What can a government do to stimulate the economy? (3)

Increase spending in certain areas

Issue tax cuts

Borrow money (budget deficit)

What are the effects of fiscal stimuli? (3)

1. Unemployment goes down

2. Demand for Labor goes up

3. Output increases

What is the general idea behind the multiplier effect?

As consumers work more and income increases, it will have downstream effects on the overall movement and velocity in the economy, ultimately multiplying the effect of a single dollar spent by the government in stimulus.

Measures of multiplier effect (2)

1. Job Multiplier

2. Spending Multiplier

Job Multiplier

#of jobs created by single gov job being introduced

Spending Mutliplier

change in GDP created by one additional gov dollar being spent

Determinants of usefulness of stimulus (2)

1. Marginal Propensity to Consume (MPC)

2. Overseas Leakage

Overseas Leakage

A situation where stimulus money contributes to spending in other economies

Marginal Propensity to Consume

Measured on a scale from 0 to 1 (1 being more spending)

Measures the portion that households spend on each additional dollar of income.

What type of household typically has a higher MPC?

Poor Households

What do badly placed stimulus dollars do to the economy and why?

They contribute to rising inflation

When the government attempts to stimulate economic sectors that are already doing well, this leads to increased wages because workers are able to demand more for their labor. This then leads to increased prices and eventually inflation.

Stimulus effect in a recession (why?)

In a recession, the effect will be greater on the economy.

the effect will be small on inflation

(this is because the multiplier will not re-employ people, but rather employ them at a rage wate reflective of the economy).

Stimulus in an expansion

Will have a smaller effect on the economy

Greater effect on inflation

(precisely the opposite reasons as recession)

What do taxes do to disposable income

They lower it

What can we do to stimulate the economy with taxes?

Issue tax cuts

What do tax cuts do to disposable income?

they raise it in the short run

What should we remember about all methods of stimulus

They all are focused on the Short Run, where things are variable.

Contractionary

Something that reduces output and increases unemployment.H

How can we measure the efficacy of a tax cut?

Through the tax multiplier

Tax Multiplier

The increase in GDP for a $1 cut in taxes.

What two forces effect the efficacy of a tax?

MPC and Overseas Leakage

When do governments borrow money

When there is a gap in between spending and revenue

How can they borrow money?

By issuing bonds

What effect can running a budget deficit have?

It can stimulate an economy

How does a budget deficit stimulate an economy? (2)

1. Stimulus w/o raising taxes

2. Cut taxes w/o cutting spending

Negative effect of gov borrowing:

Crowding Out

Crowding out

When a government borrows money, it is just like any other borrower, but since it has a much higher demand, this can lead to:

A higher interest rate (D shifts right)

A decrease in private investment (no space to borrow)