Economic test next week

  1. Expansionary Fiscal Policy
    Definition: Uses discretionary government spending or taxes to stabilize the economy.

    Types of Government Spending:

    • Mandatory Spending

      • Automatic and written into law (e.g., Social Security).

      • Accounts for 63% of federal budget.

    • Discretionary Spending

      • Requires annual review (e.g., Transportation, Education, Science).

    Impact on Aggregate Demand:

    • Increases spending or reduces taxes to correct recessionary gaps.

    • Example: Government spending rises, moving aggregate demand from AD1 to AD2, leading to a $20 billion recessionary gap.

    • If MPC = 0.75, a tax cut of $6.67 billion is needed to match a $5 billion spending increase.

    Budget Deficits and National Debt:

    • Can create budget deficits as spending exceeds tax revenues.

    • Deficits financed through government securities increase national debt.

  2. Contractionary Fiscal Policy
    Purpose: Reduces inflationary gaps when aggregate demand rises.

    Mechanisms:

    • Involves tax increases and reduced government spending.

    Considerations:

    • Must take into account the ratchet effect; prices may not return to previous levels.

    • Example: If MPC is 0.75, to reduce consumption by $3 billion, taxes must increase by $4 billion.

    • The multiplier effect can lead to a total reduction of $12 billion in GDP.

    Budget Surplus:

    • Can create a surplus where tax revenues exceed spending if the government begins with a balanced budget.

    • Surplus can reduce national debt.

  3. Government Perspectives on Policy

    • Conservatives: Prefer smaller government role; favor tax cuts in recessions and spending cuts in inflation.

    • Liberals: Prefer larger government role; support spending increases in recessions and tax increases in inflation.

  4. Automatic Stabilizers
    Definition: Programs that automatically adjust spending/taxes during economic instability.

    Key Examples:

    • Transfer Payments: Increase during recessions as unemployment rises.

    • Progressive Income Taxes: Higher earners pay a larger percentage, benefiting tax revenue during growth.

    Impact on Federal Budget:

    • Balanced budgets tend to go into deficit during recessions and into surplus during growth.

    • Automatic stabilizers are often not sufficient to manage significant demand swings, necessitating active government intervention.