Lecture 26 ECON 2030

ECON 2030 PRINCIPLES OF MACROECONOMICS

Instructor: Yushang Wei
Lecture 26

THE GOVERNMENT BUDGET AND TOTAL SPENDING

  • GDP Definition:

    • The formula for Gross Domestic Product (GDP) is given as:
      GDP=C+I+G+X−IMGDP = C + I + G + X - IM
    • Where:
      • C = Consumption
      • I = Investment
      • G = Government spending
      • X = Exports
      • IM = Imports

  • Government's Role:

    • The government directly controls G (government spending) and indirectly affects C (consumption) and I (investment).

  • Mechanisms of Influence:

    • Tax Changes:
    • Changes in taxes alter disposable income.
    • This alteration influences consumer spending as consumers have more or less income to spend based on the level of taxes.
    • Investment Influence:
    • The government's tax policies and regulations also impact business investment decisions.

  • Aggregate Demand Curve:

    • Because the government can affect the spending behavior of consumers and firms, it has the capacity to shift the aggregate demand curve.
    • This shift in demand is important for achieving economic goals, such as growth or stability.

WHAT IS FISCAL POLICY?

  • Purpose of Shifting Aggregate Demand:

    • The government aims to shift the aggregate demand curve in order to address economic imbalances:
    • To close a recessionary gap (when actual output is less than potential output).
    • To close an inflationary gap (when actual output exceeds potential output, leading to inflation).

  • Fiscal Policy Defined:

    • Fiscal policy involves the use of government tools such as:
    • Taxes
    • Government purchases of goods and services
    • Transfer payments
    • The aim is to shift the aggregate demand curve, influencing overall economic activity.

EXPANSIONARY AND CONTRACTIONARY FISCAL POLICY

  • Expansionary Fiscal Policy:

    • Defined as fiscal policy that increases aggregate demand.
    • Tools for Expansionary Fiscal Policy include:
    • Increase in Government Purchases: This directly injects money into the economy.
    • Cut in Taxes: Lowering taxes increases consumers' disposable income, encouraging spending.
    • Increase in Government Transfers: This increases the amount of money given to individuals, boosting consumption and demand.
    • The primary goal of expansionary fiscal policy is to close a recessionary gap.

  • Contractionary Fiscal Policy:

    • Defined as fiscal policy that decreases aggregate demand.
    • Tools for Contractionary Fiscal Policy include:
    • Reduction in Government Purchases: This limits government spending, reducing overall demand in the economy.
    • Increase in Taxes: Higher taxes reduce disposable income, subsequently decreasing consumer spending.
    • Reduction in Government Transfers: This decreases the financial support to individuals, resulting in lower consumption.
    • The main objective of contractionary fiscal policy is to close an inflationary gap.