Macro Notes 3.3-3.7

BIG Idea: The Economic Side of Fiscal Policy

Fiscal Policy is the use of government spending and taxes to influence the economy. It directly affects Aggregate Demand (AD) and Short-Run Aggregate Supply (SRAS), which in turn impact inflation, GDP growth, and unemployment.

Aggregate Demand (AD):

This represents the total demand for goods and services in an economy and is the sum of:

• C: Consumer Spending

• I: Investment Spending

• G: Government Spending

• Xn: Net Exports (Exports - Imports)

Why does AD shift? AD shifts because of changes in these components:

1. Consumer Spending (C)

   • Household wealth: If people feel wealthier, they are more likely to spend.

   • Consumer expectations: If consumers expect the economy to improve, they may spend more.

   • Household borrowing: If it's easier for consumers to borrow money (e.g., lower interest rates), they may increase spending.

   • Personal taxes: Lower taxes increase disposable income, encouraging more spending.

2. Investment Spending (I)

   • Real interest rates: Higher interest rates make borrowing more expensive, which can reduce investment.

   • Expected returns: If businesses expect higher profits, they will invest more.

   • Business taxes: Lower business taxes encourage investment.

3. Government Spending (G)

   • Direct impact on AD. An increase in government spending shifts AD right (expansionary policy).

4. Net Exports (Xn)

   • National income abroad: If other countries' incomes rise, they will demand more exports from your country.

   • Exchange rates: A weaker domestic currency makes exports cheaper for foreign buyers, increasing exports.

Short-Run Aggregate Supply (SRAS):

SRAS represents the total supply of goods and services that producers in an economy are willing and able to produce at different price levels in the short run.

Why does SRAS shift? SRAS can shift due to:

1. Input prices (e.g., wages, machinery, equipment): An increase in input prices makes production more expensive, shifting SRAS left (reducing output).

2. Productivity: Improvements in technology or workforce skills increase productivity, shifting SRAS right (increasing output).

3. Changes in taxes (e.g., business taxes, subsidies, regulations): Higher taxes or stricter regulations can reduce supply.

4. Government regulations: If regulations become stricter (e.g., safety laws), production costs may rise, shifting SRAS left.

Graphing the Impact of Fiscal Policy:

• AD/SRAS graphs show how aggregate demand and aggregate supply interact to determine the overall output and price level in the economy.

• LRAS (Long-Run Aggregate Supply): The long-run supply curve, typically vertical, reflects the economy's potential output when all resources are fully utilized.

• PP curves: The Production Possibility curve shows the maximum possible output combinations of two goods an economy can produce, given resources.

You may be asked to graph the effects of taxation and government spending, which can shift both AD and SRAS curves. For example:

• A tax cut could increase disposable income, shifting AD to the right.

• An increase in government spending (on infrastructure, for instance) also shifts AD to the right.

• Regulations that increase costs for businesses shift SRAS to the left.

Key Economic Indicators (CPI, GDP, Unemployment):

• CPI (Consumer Price Index) measures inflation. An increase of 6% is too high (the target is 2%), which signals inflationary pressure.

• GDP Growth: A 1% increase in GDP is considered sluggish; the target growth rate is typically between 2.5% and 6%.

• Unemployment Rate: 7% unemployment is higher than the target of 4% or lower, indicating an underperforming labor market.

Fiscal Policy Concepts:

You are likely being asked to understand and assess the impact of fiscal decisions (tax cuts, spending increases) on the economy, while keeping in mind the deficit and long-term sustainability of such policies.

Fiscal Policy in Action:

• Increasing tariffs or cutting taxes may have unintended consequences, like trade tensions or reduced government revenue.

• Spending decisions, such as cuts to entitlements, need to be made carefully to avoid future problems with debt and deficits.

The challenge with reducing the deficit is that cutting spending or raising taxes can be politically difficult, but doing nothing could lead to unsustainable national debt in the future.