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Objective – Students will be able to answer questions regarding fiscal policy.

•SECTION •1

Chapter 12- Fiscal Policy

© 2001 by Prentice Hall, Inc.© 2001 by Prentice Hall, Inc.

Full EmploymentFull Employment equilibrium exists where AD intersects SRAS & LRAS at the same point.

GDPR

PL

AD

SRASLRAS

YF

P

Fiscal PolicyGovernment 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.Decrease taxes.

Inflation is countered with contractionary policyDecrease government spendingIncrease Taxes

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Expansionary Fiscal Policy

GDPR

PL

AD

SRASLRAS

YF

P

Y

AD1

P1

IF RECESSION, THEN G↑.: AD .: GDPR↑ & PL↑ .: u%↓ & π% ↑

OR T↓ .: DI↑ .: C↑.: AD .: GDPR↑ & PL↑ .: u%↓ & π% ↑

IF INFLATION, THEN G↓ .: AD .: GDPR↓ & PL↓ .: u%↑ & π%↓

OR T↑ .: DI↓ .: C↓ .: AD .: GDPR↓ & PL↓ .: u%↑ & π%↓

GDPR

PL

AD

SRAS

LRAS

YF

P

Y

AD1

P1

Contractionary Fiscal Policy

Discretionary v. AutomaticFiscal Policies

DiscretionaryIncreasing 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.

AutomaticUnemployment 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 PolicyLags

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 MotivationPoliticians face re-election and are more likely to support expansionary rather than contractionary fiscal policy.

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).

Side-effect: ‘Crowding-out’

r%

QLF

SLF

DLF

r

q

DLF 1

r1

q1

G↑ and/or T↓ .: Government deficit spends .: DLF .: r%↑ .: IG↓

(Crowding-Out Effect)

r%

IG

ID

II1

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).

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Section 1 Assessment1. Graph and explain what would happen

to the equilibrium PL, GDPr, u%, and π% in the short run if the economy is in recession and there is an increase in government spending.

2. Describe what fiscal policy actions a government can use to stimulate the economy and contract the economy.

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Summary: In a paragraph, describe what you have learned today.