macro unit 3

UNIT 2

MODULE 2.1 - the circular flow and gross domestic product

DEFINITIONS

National income and product accounts (national accounts) keep track of the flows of money among different sectors of the economy

Product markets are where goods and services are bought and sold

Consumer spending is household spending on good and services

Factor markets are where resources especially capital and labor are bought and sold

Government spending is total expenditures on goods and services by federal, state, and local governments

Taxes are required payments to the government

Tax revenue is the total amount of funds the government receives from taxes.

Disposable income, equal to income plus government transfers minus taxes, is the total amount of household income available to spend on consumption

Government transfers are payments that the government makes to individuals without expecting a good or service in return.

Private savings, equal to disposable income minus consumer spending, is a household’s disposable income that is not spent on consumption

Financial markets channel private savings into investment spending and government borrowing

Government borrowing is the amount of funds bored by the government in the financial markets

Investment spending is spending by firms on new productive physical capital, such as machinery and structures, and on changes in inventories

Inventories are stocks of goods and raw materials held to facilitate business operations

Exports are goods and services sold to other countries

Imports are goods and services purchased from other countries

Gdp is the total value of all final goods and services produced in the economy during a given year

The expenditure approach to calculating gdp adds up aggregate spending on domestically produced final goods and services in the economy – the sum of consumer spending, investment spending, government purchases of goods and services, and exports minus imports. 

The income approach to calculating gdp adds up the total factor income earned by households from firms in the economy, including rent, wages, interest, and profit.

The value added approach to calculating gdp surveys firms and adds up their contributions to the value of final goods and services

Final goods and services are goods and services sold to the final, or end, user

Intermediate goods and services are goods and services bought from one firm by another firm to be used as inputs into the production of final goods and services

Net exports are the difference between the value of exports and the value of imports, denoted as (x-m)

The value added by a producer is the value of its sales minus the value of its purchases of inputs

National accounts (national income and product accounts) keep track of the flows of money among different sectors of the economy

Circular flow diagram - simplified representation of the economy, idea that flowing in = flowing out

Simple circular flow diagram

• Transactions = two types of flows, physical things (goods/services/labor/materials) in one direction and payments in the opposite direction

• Two groups = firms and households

• Two kinds of markets = factors and product markets

  • Product markets are where goods and services are bought and sold 

    • Consumer spending is household spending on goods and services

  • Factor markets are where resources are bought and sold

Expanded circular-flow diagram - shows government involvement

• Injects funds into flow through government spending and funds leak out through taxing ?

• Government spending it total expenditures on goods and services by federal, state, and local governments

• Taxes are required payments to the government

• Tax revenue is the total amount of funds the government receives from taxes

• Disposable income, equal to income plus government transfers minus taxes, is the total amount of household income available to spend on consumption

• Government transfers are payments that the government makes to individuals without expecting a good or service in return

Adding in financial markets

• Disposable income not spent on consumption does show up on the flows, financial markets

• Private savings, equal to disposable income minus consumer spending, is a household’s disposable income that is not spent on consumption

• Financial markets channel private savings into investment spending and government borrowing

• “Financial markets channel private savings into government borrowing and investment spending”

• Government borrowing is the amount of funds borrowed by the government in the financial markets

• Investment spending is spending by firms on new productive physical capital, such as machinery and structures, and on changes in inventories

• Inventories are stocks of goods and raw materials held to facilitate business operations

Adding in the rest of the world

• Exports are goods and services sold to other countries (injection)

• Imports are goods and services purchased from other countries (leakage)

• Also foreign lending (funds into US from the rest of the world)

Gross domestic product / GDP is the total value of all final goods and services produced in the economy during a given year

• In given time (normally a year), total value of all final goods and services produced in a country

• Nominal and real (adjusted for price changes)

• Three ways to measure

  • The expenditure approach to calculating GDP adds up aggregate spending on domestically produced final goods and services in the economy (the sum of consumer spending, investment spending, government purchases of goods and services, and exports minus imports)

    • Final goods and services are goods and services sold to the final, or end, user

    • Intermediate goods and services are goods and services bought from one firm by another firm to be used as inputs into the production of final goods and services

    • Four groups that purchase goods/services → households, firms, government, people in foreign countries

    • C = largest category of spending aka consumer spending by households, I = investments by firms, G = government purchases, C = spending by foreigners, M = spending on imports

    • Net exports are the difference between the value of exports and the value of imports, denominated as (X-M)

GDP = C + I + G + ( X – M )

• The income approach to calculating GDP adds up the total factor income earned by households from firms in the economy, inducing rent, wages, interest, and profit

• The value-added approach to calculating GDP surveys firms and adds up their contributions to the value of final goods and services

  • The value added by a producer is the value of its sales minus the value of its purchases of inputs

2.2

Non Market transactions involve goods and services that are not bought and sold in a legal market

GDP was invented post great depression, helped in wwii

Components of GDP

• Government purchases of goods and services

• Investment spending

• Consumer spending

• Net exports (can be ‘-’)

GDP = all final goods and services, induces investments by firms in new capital goods, new construction of structures, and inventories

Not included in GDP

• Intermediate goods, used goods, financial assets (stocks/bonds), transfer payments, imports

• Not included to avoid double counting

• A bond represents a promise to repay with interest, a stock represents ownership in a firm

• Also non market production → excluding leads to an underestimate

  • Non Market transactions involve goods and services that are not bought and sold in a legal market

GDP can tell us the size of an economy (compared to other countries), increases in GDP often represent increases in the price of goods and services vs just an increase in output – measure of economic performance

2.3 notes

Employed people are currently holding a job in the economy, either full time or part time

Not working ≠ unemployed (retirement, disability)

Unemployment people are actively looking for work but aren’t currently employed

• Jobless, looking for jobs, and available for work

The labor force is equal to the sum of the employed and the unemployed

The labor force participation rate is the percentage of the working age population (those aged 16 or older in the United States) that is in the labor force

Labor force participation rate=Labor forcePopulation age 16 and older100

The unemployment rate is the percentage of the total number of people in the labor force who are unemployed 

Unemployment rate=Number of unemployed workersLabor force100

Gets data from random samples, unemployment rate tells us how hard/difficult it is to get a job, good indicator of current labor market conditions

Discouraged workers are non working people who are capable of working but have given up looking for a job due to the state of the job market

• Because not counted, unemployment estimate might be a little low

Underemployed are workers who would like to work more hours or who are overqualified for their jobs

• Because not counted, understates level of joblessness in economy

Labor underutilization aka unemployed + discouraged

Unemployment could be overstated because of the time it takes to find a new job

Unemployment varies for demographic groups (age, race, gender)

Frictional unemployment is unemployment due to the time workers spend in job search

• Job search is needed because all workers are different

• Inevitable because of sontrant process or job creation/destruction and new workers are always entering the labor market

• Higher unemployment, workers tend to be jobless for longer, less frictional unemployment (long term unemployment)

• Public policy tries to help during in between time

Structural unemployment is unemployment that results when workers lack the skills required for the available jobs, or there are more people seeking jobs in a labor market than there are jobs available at the current wage rate

• Mismatch between supply and demand in labor markets

The natural rate of unemployment is the unemployment rate that arises from the effects of frictional plus structural unemployment

Natural unemployment=frictional+structural

• normal/minimum feasible

• Changes…

  • Changes in labor force characteristics - age, babyboom

  • Changes in labor market institutions - (LMI = policy interventions and organizations that impact) labor unions, networking sites, technology

  • Changes in government policies - minimum wage (raise), job training and subsidies (less)

Cyclical unemployment is the deviation of the actual rate of unemployment from the natural rate

Changes in the natural rate of unemployment

Actual unemployment=natural+cyclical

2.4 notes

A rising overall price level is inflation. A falling overall price level is deflation.

• Both cause problems, inflation = stop holding cash, prices rise, cash loses value – deflation = hold cash and deepend recession

Brining down the rate of increase in the price level = disinflation (different than decrease in price level)

The economy has price stability when the overall price level is changing only slowly if at all

Level of prices don’t matter – prices and wage will change (nominal changes aka unadjusted for inflation, but real does not change if adjusted for inflation)

The real wage is the wage rate divided by the price level to adjust for the effects of inflation or deflation

Real income is income divided by the price level to adjust for the effects of inflation or deflation

The inflation rate is the percentage increase in the overall level of prices per year 

Inflation rate=Price level in year 2 - Price level in year 1Price level in year 1100

The aggregate price level is a measure of the overall level of prices in the economy

A market basket is a hypothetical set of consumer purchases of goods and services

• Consumption bundle and average price change 

The base year is the year arbitrarily chosen for comparison when calculating a price index. The price level compares the price of the market basket of goods in a given year to its price in the base year

A price index measures the cost of purchasing a given market basket in a given year. The index value is always equal to 100 in the selected base year

Price index in a give year=Cost of market basket in a give yearCost of market in base year100

Inflation rate=Price index year 2 - Price index in year100

The consumer price index, or CPI, measures the cost of the market basket of a typical urban American family

• Politically sensitive number bc involved in people's lives, somewhat accurately measures inflation

Reasons CPI is inaccurate or might overstate (always tweaking and improving accuracy)

• Substitution bias occurs in the CPI because, overtime, items with prices that have risen most receive too much weight (because households substitute away from them), while items with prices that have risen least are given too little weight (because households shift their spending toward them)

• Looks at things over four years but come goods might have been swapped out in that time so not perfect look

• Product improvements - ‘new and improved’ product improves but price doesn’t, hard to capture

• Innovation - creates benefits similar to those of a fall in consumer prices because tech makes things cheaper

The producer price index, or PPI, measures the prices of goods and services purchased by producers

GDP deflator – used to adjust GDp for changes in price level (2.6)

2.5 notes

Expected costs of inflation

• Shoe leather costs (holding cash)

  • Increased costs of transactions caused by inflation

  • Alludes to wear and tear caused on shoes by running around and trying to avoid holding money, substantial in high inflation economics (but small in US)

  • People hold onto their money for efficient use, high inflation rate discourages form holding money leads for people to reduce the amount of money they hold

  • Aka convert to foreign currency (or something more stable) but gave up resources to of (ie way more bankers)

• Menu costs (listed price change)

  • Changing a listed price has a real cost aka menu cost

  • Like when supermarket workers spend all their time relabeling prices and so they wind up just putting prices in terms of a stable currency

  • Also present in low inflation economies but not as severe (sporadic and not constant)

• Unit-of-account cost (dollars)

  • The role of dollar as a basis of contracts and calculator

  • Can be degraded by inflation because purchasing power changes, economist think it makes for worse economic decisions because of the uncertainty of the value of the dollar

  • Makes money a less reliable unit in inflation

  • Important for taxes

Unexpected inflation can be good or bad for different groups

• Helps some while hurting others - loans/economic transactions that take time and are nominal, depending on rate, the real cost might help you

• Interest rate on a loan - difference between nominal and real rates

• If inflation is higher than expected, borrowed gain from lenders (funds can be used to purchase less goods)

• If inflation is lower than expected, lenders gain from borrowers (funds can be used to purchase more goods)

• Mortgages are biggest winners/losers

• Unexpected deflation also creates winners and losers

The nominal interest rate is the interest rate actually pair for a loan

The real interest rate is the nominal interest rate minus the rate of inflation

Disinflation is the process of bringing the inflation rate down

• Harder and costly once it is established in an economy

2.6 notes

Aggregate output is the total quantity of final goods and services produced within an economy

• Needed to accurately measure output, used to calculate real GDP

• To eliminate, how much would the GDP have gone up if prices has not changes

Real GDP is the total value of all final goods and services produced in the economy during a given real, calculated using prices of a selected base year in order to become the effects of price changes

• Comes with information about what the base year is

• GDP growth is part inflation and part growth (reflect price changes and changes value of dollar)

• What economists use when comparing countries

Nominal GDP it the total value of all final goods and services produced in the economy during a given year, calculated with the prices current in the year in which the output is produced

The GDP deflator for a given year is 100 times the ratio of nominal GDP to real GDP in that year

GDP deflator=(nominal GDP/real GDP)100

GDP per capita is GDP divided by the size of the population; it is equivalent to the average GDP per person

Real GDP doesn’t measure — not a sufficient measure of human welfare in the country

• People get happy from things that don’t cost money and spend more money on bad things (ie divorce)

• Higher = can afford better things as a country

• Weather you use the money to improve your life is up to you and isn’t reflected

2.7 notes

The business cycle is the alternation between economic downturns, known as recession, and economic upturns, known as expansions

Recessions are periods of economic downturn when output and employment are falling. The through of a business cycle is the lowest point of a recession, before the economy starts to expand. Expansions, or recoveries, are periods of economic upturns when output and employment rise. The peak of a business cycle is the highest point of an expansion before the economy goes into a recession. A depression is a very deep and prolonged downturn.

How do we know/measure recession

• NBER decides dates, IDs recession based on decline in economic activity that is spread across economy for more than multiple months

• Not just confined to one part of economy

• peak/trough based on data from income, unemployment, consumption spending, sales, production industrial - not fixed rule - more emphasis on income and employment, real GDP is also used

• Only know what phase of the data cycle we were in because they have to wait for the data (neven know our current states)

Phasa of a business cycle

Downturn because recession – normally after two quarters of the economy falling, data put into table w/ peaks and troughs and timelines

Recession is undesirable (not as bad as depression) - leads to joblessness, less production, reduce income, lower living standard / in recession, unemployment rate increases, during expansion it is falling

Output is important too – directly relates to unemployment, can find form looking at real GDP

Economic growth is an increase in the maximum amount of goods and services an economy can produce

• Fundamental for prosperity - rise in output per person = higher wage, higher standard of living

Full-employment level of output is the level of real GDP the economy can produce when all resources are fully employed. Potential output is what an economy can produce when operating at maximum sustainable employment (that is, at the natural rate of unemployment). The output gap is the difference between actual and potential output

All the random little red boxes from this unit

draw the simple circular-flow diagram with two markets (product markets and factor markets) and two sectors (firms and households). Add the government sector and correctly label the markets and sectors and the flows between them. Add the financial and international sectors to you diagram to help you understand the expanded model we will build throughout later modules 2.1

know that resources can be divided into four categories and there payments – labor:wages / land:rent / capital:interest / entrepreneurship:profit 2.1

exports represent the flow of goods and services out of the economy into another country, with payment for the exports flowing back in. imports represent the flow of goods and services into the economy from another country, with payments for the imports flowing back out. Because of this constant exchange of goods and services and payments, we focus on net exports (X-M) 2.1

if X > M, then net exports will be positive, indicating a new outflow of goods and services and a net inflow of payments / if M > X, then net exports will be negative, indication a net inflow of goods and services and a net outflow of payments 2.1

the expenditure approach is the basis for the model of the macroeconomy presented in this course, you should be family with all three methods for finding GDP 2.1

know what is and is not included in GDP. included = domestically produced final goods and services, capital goods, new construction of structures, and changes to inventories. not included = nonmarket transactions, intermediate goods and services, inputs, used goods, financial assets such as stocks and bonds, and foreign produced goods and services 2.2

you will need to calculate the size of the labor force participation rate, the labor force, and the unemployment rate. Remember: an unemployed person must be willing and able to work and be active in seeking employment. The labor force is made up of both employed and unemployed people. The labor force participation rate is the percentage of the working age population in the labor force, and the unemployment rate is the percentage of the labor force that is unemployed 2.3

GDP and unemployment move in opposite directions because more production means more workers must be hired, and less production means fewer workers hired 2.3

know how to identify the type of unemployment – frictional, structural, or cyclical – given a specific scenario 2.3

Frictional unemployment always exists in an economy because there will always be people looking for jobs – either their first job or a better job. When describing this concept, remember that frictional unemployment does not necessarily indicate a problem for the economy, and a limited amount of it is eve a good thing if people are finding jobs that match their skills and preferences 2.3

make sure you can recognize examples of structural unemployment. Its causes include a mismatch between workers’ skills and job requirements, technological change, and automation. Job training is a way to address structural unemployment 2.3

The natural rate of unemployment is never zero because frictional employment alway exists. Think of the natural rate as the lowest possible level of unemployment that can be breached — a level that will be identified in the models of the macroeconomy presented later in the course. Numerical estimates of the natural rate differ based on when, where, and why they are estimated, but the concept of the natural unemployment rate is always the same 2.3

“Real” values (including real wages, real income, real interest rates, and real GDP) have been adjusted for changes in the price level – whether through inflation or deflation – while economical values have not. You can remember the difference between real and nominal thinking, “Nominal, now!” 2.4

The term market basket refers to a group of goods and services that represent what consumers buy. On the ap exam, market baskets usually consist of three or four goods,  simplification of the market basket used to compute the Consumer Price Index, of CPI, the most commonly used price index 2.4

any year can be chosen as the base year. If the price of a market basket is higher in a given year than in the base year, the price index will be greater than 100; if it is lower, the price index will be lower than 100. Remember: the price index in the base year is always equal to 100 because base prices in the base year are always 100% of what they are in the base year! 2.4

explain the shortcomings of CPI as a measure of inflation, especially how substitution bias causes the CPI to overstate the true inflation rate 2.4

you should know the producer price index (PPI) and understand how it differs from the CPI, but calculating the PPI is beyond the scope of the course 2.4

In general, borrowers are helped by inflation because it decreases the real value of what they must repay. Lenders, savers, and people with fixed incomes are hurt by inflation because it decreases the real value of the money available to them in the future 2.5

to distinguish between “real” and “nominal” values for a variety of variable, such as income, wages, and interest rates, remember that real values have been adjusted for price changes (for example, inflation), and nominal values, which use current prices, have not 2.6

in addition to defining and calculating real GDP, make sure you understand the limitations of GDP for measuring economic welfare 2.6

be prepared to identify different phases of the business cycle so you can relate each phase to changes in employment, output, and unemployment 2.7

For the AP exam you should know that some increases in output do now represent economic growth. Economic growth is an increase in the economy’s potential output. Temporary fluctuations in economic conditions after alter real GDP (output) when where has ben no change in the economy’s potential output 2.7

3.1

Definitions

• Wealth is the value of a household’s accumulated savings

• Planned investment spending is the investment spending that businesses intend to undertake during a given period

• Inventory investment is the value of the change in inventories held in the economy during a given period

• The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world

• The real wealth effect of a change in the aggregate price level is the change in consumer spending caused by the altered purchasing power of consumers’ assets

• The interest rate effect of a change in the aggregate price level is the change in investment and consumer spending caused by altered interest rates that result from changes in the demand for money

• The exchange rate effect of a change in the aggregate price level is the change in net exports caused by a change in the value of the domestic currency, which leads to change in the relative price of domestic and foreign goods and services. 

3.2

• The marginal propensity to consume, or MPC, is the increase in consumer spending when disposable income rises by $1

• The marginal propensity to save, or MPS, is the increase in household savings when disposable income rises by $1

• The expenditure multiplier is equal to 1/(1-MPC) or 1/MPS. It is the ratio of the total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change in aggregate spending to the size of that autonomous change. It indicates the total rise in real GDP that results from each $1 of an initial rise in spending. 

• The tax multiplier, which is equal to -MPC/(1-MPC), is the factor by which a change in tax collections changes real GDP

3.3

• The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy 

• The nominal wage is the dollar amount of the wage paid 

• Sticky wages are nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of Labor shortages 

• The short-run aggregate supply curve  shows the positive relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run, the time period when many production costs can be taken as fixed. 

3.4

• The short run is the time period in which many production costs, including nominal wages, are not fully flexible 

• The long run is the time period in which all prices, including nominal wages, are fully flexible 

• The long run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible 

• Potential output is the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible. It represents the economy's maximum sustainable production capacity.

• The Full Employment output level is the level of real GDP the economy can produce if all resources are fully employed 

3.5

In the AD-AS model, the aggregate supply curve and the aggregate demand curve are used together to analyze fluctuations in the price level and real GDP

SRAS curve crossing the AD curve

The short-run macroeconomic equilibrium occurs where the quantity of aggregate output supplied is equal to the quantity of aggregate output demanded – that is, where the AD and SRAS curves intersect

The short-run equilibrium aggregate price level is the aggregate price level in the short-run macroeconomic equilibrium. Is it identified on the vertical axis of an AD-AS graph

Short-run equilibrium aggregate output is the quantity of aggregate output produced in the short-run macroeconomic equilibrium. It is identified on the horizontal axis of an AD-AS graph

Long-run macroeconomic equilibrium occurs when a short-run macroeconomic is at the full level of employment (on the LRAS curve)

The output gap is the difference between actual aggregate output and potential output

There is a recessionary gap when aggregate output is below potential output (left of LRAS)

There is an inflationary gap when aggregate output is above potential output (right of LRAS)

Basically it is either in equilibrium or there is a shift that causes a recessionary or inflationary gap

3.6

An event that shifts the aggregate demand curve is a demand shock

An event that shifts the short-run aggregate supply curve is a supply shock

Negative demand shock (aka AD shifts left, a negative demand shock leads to lowed aggregate price level and lower aggregate output) / raise prosecution costs and reduces the quantity producers are willing to supply at any level, leftward shift

Positive demand shock (aka AD shifts right, a positive demand shock leads to a higher aggregate price and level and higher aggregate output) / reduces production costs and increase quantity eupplied, leading to rightward shift

Stagflation is the combination of inflation and stagnation (or falling) aggregate output

Negative supply shock → shifts SRAS left and leads to lower aggregate output and a higher aggregate price level

Positive supply shock → shifts SRAR right and leads to higher aggregate output and a lower aggregate price level

Cost-push inflation is inflation that is caused by a significant increase in the price of an input with economy-wide importance

Demand-pull inflation is inflation that is caused by an increase in aggregate demand

3.7

1. In the long run, in the absence of government policy actions, flexible wages and prices will adjust to move the economy back to long run equilibrium at the full employment level of aggregate output after a shock to aggregate demand or short run aggregate supply. If actual aggregate output exceeds potential output, nominal wages will eventually rise in response to low unemployment and aggregate output will fall. If potential output exceeds actual aggregate output, nominal wages will eventually fall in response to high unemployment and aggregate output will rise.

2. Shifts in the long run aggregate supply curve indicate changes in the full employment level of output and economic growth.

3.8

Fiscal Policy is the use of government purchases of goods and services, government transfers, or tax policy to stabilize the economy.

Expansionary fiscal policy increases aggregate demand to close a recessionary gap; it involves the government increasing spending or transfer payments or decreasing taxes. 

Contractionary fiscal policy decreases aggregate demand to close an inflationary gap; it involves the government decreasing spending or transfer payments, or increasing taxes. 

The balanced budget multiplier is the factor by which a change in both spending and taxes changes real GDP

1. The high cost – in terms of unemployment – of a recessionary gap and the future adverse consequences of an inflationary gap lead many economists to advocate active stabilization policy: using fiscal policy to offset demand shocks. The government’s fiscal policy tools are government spending, and taxes and transfers. 

2. Negative supply shocks pose a policy dilemma: a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflation, but a policy that counteracts inflation by reducing aggregate demand will deepen the output slump.

3. Government purchases of goods and services directly affect aggregate demand and changes in taxes and government transfers affect aggregate demand indirectly by changing households’ disposable income. Expansionary fiscal policy is used to restore full employment when the economy is in a negative (recessionary) gap. Expansionary fiscal policy shifts the aggregate demand curve rightward, leading to an increase in real GDP; contractionary fiscal policy is used to restore full employment when the economy is in a positive (inflationary) output gap. Contractionary fiscal policy shifts the aggregate demand curve leftward, leading to a decrease in real GDP

4. Fiscal policy has a multiplied effect on the economy. Because part of any change in taxes or transfers is absorbed by savings in the first round of spending, changes in government purchases of goods and services have a larger multiplier than taxes and transfers. The balanced budget multiplier indicates the total increase in aggregate spending that results from each $1 increase in both government spending and taxes will equal $1.

5. In reality, implementing discretionary fiscal policy involves lags between the time a demand shock occurs and the time it takes to decide on and implement a policy action.

3.9

Discretionary fiscal policy is fiscal policy that is the result of deliberate actions by policy makers rather than rules. 

Automatic stabilizers are government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands.

1. Rules governing taxes and some transfers act as automatic stabilizers, reducing the size of the expenditure multiplier and automatically reducing the size of output gaps. In contrast, discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle.

2. Automatic stabilizers increase income during recessions and decrease income during expansions, to partially offset changes in aggregate demand and reduce output gaps. Tax revenues increase automatically as GDP rises, slowing consumption and preventing the economy from overheating. Tax revenues decrease automatically as GDP falls, preventing consumption and the economy from declining further. Social service transfer programs also act as automatic stabilizers, offsetting increases and decreases in income through corresponding decreases and increases in eligibility for transfer payments.