Chapter 12 - Fiscal Policy

Lecture notes + Textbook notes

What is "fiscal policy"?

Changes in government spending and taxes to achieve macroeconomic policy objectives.

• government spending or taxation

Who is responsible for fiscal​ policy?

The federal government controls fiscal policy

Discretionary fiscal policy

Changing government spending, taxes, or transfers to shift the AD curve  

What fiscal policy do governments use during a recession?

They use expansionary fiscal policy 

• Meaning they want to increase aggregate demand, or shift it out to the right

What fiscal policy do governments use during an expansion/boom?

They use contractionary fiscal policy 

• Meaning they shift AD to the left by decreasing government spending

Automatic Stabilizers 

Changes in taxes and transfers kick in (automatically) when income fluctuates 

Why are automatic stabilizers called “automatic”?

They work without the government needing to pass new laws.

What is the goal?

Economy returns to long-run eq. after a shcok

What happens to taxes and transfers when GDP falls?

Taxes decrease and transfers (like EI and welfare) increase.

How do automatic stabilizers affect income during a recession?

They prevent income from falling as much.

Monetary policy

Changes in the money supply

How do automatic stabilizers impact aggregate demand (AD)?

They reduce fluctuations in AD.

How does the business cycle change with automatic stabilizers?

Fluctuations become smaller and less extreme.

What happens to AD after a negative shock without automatic stabilizers?

AD shifts left significantly (larger decrease).

What happens to AD after a negative shock with automatic stabilizers?

AD still shifts left, but by a smaller amount.

How do automatic stabilizers affect movement around LRAS?

The economy still fluctuates around LRAS, but with smaller swings.

What is expansionary fiscal policy?

Includes increasing government spending and decreasing taxes to increase aggregate demand.

What is contractionary fiscal policy?

Includes decreasing government spending and increasing taxes to decrease aggregate demand. 

Spending multiplier

1/ (1-MPC)

Why does the spending multiplier work?

Initial spending raises income → more consumption → more income

Closed economy AD

Y = C + I + G

Government purchases multiplier formula

Multipliers

• Government purchases multiplier

• Tax Multiplier

• Balanced budget multiplier

Balanced budget multiplier

• Suppose that the government wants to increase government spending without increasing the government budget deficit  

• Used in cases where you want to increase in G and increase T by the same amount  

Tax Multiplier Formula

Tax multiplier sign

ALWAYS Negative

Why is tax multiplier negative?

↑ taxes → ↓ consumption

Why is the tax multiplier smaller?

Only part of disposable income is consumed (MPC)

Tax multiplier meaning

Change in GDP from $1 change in taxes

Getting the timing for fiscal policy right can be difficult because….

1. Control over monetary policy is concentrated in the hands of the Bank of Canada

2. Even after a change in fiscal policy has been approved, it takes time to implement the policy

Crowding Out

A decline in private expenditures as a result of an increase in government purchases

What happens to interest rates when income (GDP) rises?

Money demand ↑ → interest rates ↑

How do higher interest rates affect private spending?

↓ consumption, ↓ investment, ↓ net exports

Why do net exports fall when interest rates rise?

Higher rates → ↑ demand for CAD → currency appreciates → exports ↓, imports ↑

Crowding out in the short-run

Interest rates rise → some private spending falls → GDP still increases, but less

Crowding out in the long-run

Interest rates rise → private spending fully falls → no increase in GDP

Budget deficit

Government expenditures > Government tax revenue

Budget surplus

Government expenditures < Government tax revenue

Budget deficits occur automatically during recessions for two reasons

1. Wages and profits fall, causing government tax revenues to fall

2. Govn. automatically increases its spending on transfer payments (like EI)

The cyclically adjusted budget deficit or surplus

Measures what the deficit or surplus would be if the economy were at potential GDP.

Cyclically adjusted budget deficit or surplus - Expansionary fiscal policy

Should result in a cyclically adjusted budget deficit

What is a cyclically adjusted budget deficit?

Deficit if GDP were at potential

Cyclically adjusted budget deficit or surplus - Contractionary fiscal policy

Should result in a cyclically adjusted budget surplus.

How do automatic deficits help in a recession?

Keep spending higher → reduce severity

Why does tax revenue fall in a recession?

Wages and profits fall

The Federal Government Debt

The total amount the government owes, equal to the sum of all past budget deficits minus surpluses

Tax Wedge

The difference between the pretax and posttax return to an economic activity

Lower tax wedge (lower taxes)

↑ labour supply (people work more)  

↑ saving  

↑ investment  

Higher tax wedge (higher taxes)

↓ labour supply  

↓ saving  

↓ investment 

Effect of cutting taxes on aggregate supply

Increases AS (more economic activity

What is tax simplification?

Making the tax system less complex

How does a complex tax system affect the economy?

Distorts decisions and reduces efficiency

Expansionary policy

• Goal: Increase AD

• Increase G or decrease T

Contractionary policy

• Goal: Decrease AD

  • further increases in Ad would cause inflation to go up (price level)

• Decrease G or increase T

Types of lags

• Fiscal policy —> Front-end

• Monetary —> Back-end

Policy coordination

• BoC --> Monetary policy to increase AD 

• Federal government --> fiscal policy to decrease AD  

What is the difference between federal purchases and federal​ expenditures?  

• Federal purchases

  • Require that the government receive a good or service in​ return

• Federal expenditures

  • Include transfer payments.