AP Macroeconomics Mechanics of Fiscal Policy

AP Macroeconomics
Mechanics of Fiscal Policy
Fiscal Policy
• Government efforts to promote full
employment and price stability by
changing government spending (G)
and/or taxes (T).
• Recession is countered with expansionary
policy.

)

– Increase government spending (G
– Decrease taxes (T )
• Inflation is countered with contractionary
policy


– Decrease government spending (G )
– Increase Taxes (T )
Expansionary Fiscal Policy


or T


If G
,then AD shifts  causing PL and GDP ,which causes u%
Notice that the PL increased: this means expansionary
fiscal policy creates some inflation.

In order to combat recession, the government engages
in expansionary policy.
Expansionary Fiscal Policy
LRAS
PL
SRAS

P

P1
AD1
AD

Y
YF
GDPR
IF RECESSION, THEN G↑.: AD  .: GDPR↑ & PL↑ .: u%↓ & π% ↑
OR
T↓ .: DI↑ .: C↑.: AD  .: GDPR↑ & PL↑ .: u%↓ & π% ↑
Contractionary Fiscal Policy
and GDP , which causes u%

causing PL

,then AD shifts

or T
Notice that the u% increased: this means contractionary
fiscal policy creates some unemployment.


If G

In order to combat inflation, the government engages
in contractionary policy.
Contractionary Fiscal Policy
LRAS
PL
SRAS

P

P1
AD
AD1

YF
Y
GDPR
IF INFLATION, THEN G↓ .: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓
OR
T↑ .: DI↓ .: C↓ .: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓
Government choice vs. Gonna Happen
• Discretionary
– Increasing or
Decreasing
Government Spending
and/or Taxes in order to
return the economy to
full employment.
Discretionary policy
involves policy makers
doing fiscal policy in
response to an
economic problem
• Automatic
– Unemployment
compensation &
marginal tax rates are
examples of
automatic policies
that help mitigate the
effects of recession
and inflation.
Automatic fiscal
policy takes place
without policy makers
having to respond to
current economic
problems.
Weaknesses of Fiscal Policy
• Lags
– Inside lag – it takes time to recognize economic
problems and to promote solutions to those problems
– Outside lag – it takes time to implement solutions to
problems
• Political Motivation
– Politicians face re-election and are more likely to
support expansionary rather than contractionary fiscal
policy.
– Increased government spending and decreased taxes
are almost always more popular with voters than
increased taxes and decreased spending.
Expansionary Fiscal Policy Side-effect:
‘Crowding-out’ of Investment and Net Exports

A possible side-effect of increased government spending
and reduced taxes is a budget deficit which may lead to
the ‘crowding-out’ of Gross Private Investment (IG) and
Net Exports (XN)


When G or T , then government must borrow in order to continue
spending. This leads to an increase in the demand for loanable funds
or a decrease in the supply of loanable funds, which results in r % .
This change in r % leads to IG . In addition, the increase in r% causes
 as investors seek higher returns in the U.S. This leads to
D
$ and/or S$
$ which leads to X and M , so XN . Because IG and XN are direct
components of AD, these decreases offset some of the increase in AD.





Expansionary Fiscal Policy
Side-effect: ‘Crowding-out’
SLF
r%
r%
r1
r
DLF 1
ID
DLF
q
q1
QLF
I1
I
G↑ and/or T↓ .: Government deficit spends .: DLF  .: r%↑ .: IG↓
(Crowding-Out Effect)
IG
Contractionary Fiscal Policy Side-effect:
‘Crowding-in’ of Investment and Net Exports
A possible side-effect of decreased government spending
and increased taxes is a budget surplus which may lead to
the ‘crowding-in’ of Gross Private Investment (IG) and
Net Exports (XN)


When G or T , then government develops a budget surplus
This leads to a decrease in the demand for loanable funds
or an increase in the supply of loanable funds, which results in r % .
This change in r % leads to IG . In addition, the decrease in r% causes
D$ and/or S$ as investors seek higher returns abroad. This leads to
$ which leads to X and M , so XN . Because IG and XN are direct
components of AD, these increases offset some of the decrease in AD.








Classical/Neo-Classical
Competition is good, efficient, and self improving
(“Invisible Hand”).
Markets self correct through suppliers (Say’s Law).
Conservatives and modern Republicans tend to support
this.
Government’s role is to stop cheating, monopolies,
unions.
Leave the rest of the economy alone (Laissez Faire).
Keynesian Economics
1930’s to present times
“In the long run, we are all dead.”
Society can’t wait for the economy
to repair itself, and the economy
can never actually repair itself.
Economies are inefficient, wages
are sticky, costs are affected by the
Ratchet Effect, businesses cheat.
Supply never creates its own
demand.
Keynesian/Neo-Keynesian
Competition is good but always flawed b/c of…..
Sticky Wages – nominal wages that are slow to fall even in the face
of high u% and slow to rise even in the face of labor shortages
Ratchet Effect - A ratchet analogy is a good way to think about the
effects of changes in aggregate demand on the price level. A
ratchet is a tool or mechanism such as a winch, car jack, or socket
wrench that cranks a wheel forward but does not allow it to go
backward.
Also…Say’s Law is mostly mythical. (French economist J. B. Say is most
commonly identified with Say's Law, which states that supply creates its own
demand.)
Mas Keynesian/Neo-Keynesian
Markets need correction and the elected body of a
republic should do the correcting (Fiscal Policy)
Liberals and modern Democrats tend to support this.
Government takes an active role in controlling
Aggregate Demand.
Create “stabilizers” like Social Security to buffer
against recessions.
Monetary School/Central Bank Policy/Federal Reserve
Policy in the US
Competition is usually good but needs quick “fine tuning”.
Congress can’t time policies correctly won’t fight inflation.
Markets are best corrected via interest rates and the use of
Money Supply.
Bankers and Fed Reserve leaders support this, the Tea Party hates
this.
The Fed Reserve takes a very active role in the manipulation of
interest rates, thus controlling Ig.
An increase in which of the following
will increase aggregate demand?
(A) Taxes
(B) Government spending
(C) The federal funds rate
(D) Reserve requirements
(E) The discount rate
(B) Government spending
When the United States government engages
in deficit spending, that spending is primarily
financed by
(A) increasing the required reserve ratio
(B) borrowing from the World Bank
(C) issuing new bonds
(D) appreciating the value of the dollar
(E) depreciating the value of the dollar
(C) issuing new bonds