Fiscal Policy

1. Taxes (ch 14)

2. Federal Budget & Debt (ch 15 sect 3)

3. Fiscal Basics (ch 15 Sect 1)

4. Policy Debate: Keynes, Classical, Supply-Side (ch 15 sect 2)

Remember??? Circular Flow Model

Remember???

• Expenditure Approach???C + ? + ? + ?

• Income Approach???Y = ???

Y = C + I + G + Xn

Remember???

• AS/AD Model???– What causes the business cycle (recessions &

Expansions)?• Which ‘Shock’ is the most common?

AD = ??????????????

AD = C + I + G + Xn*complete graphs

Circular Flow ModelExpenditure:C + I + G + Nx

Income: Y

What to do? What to do?

• What to do when we are in a recession???• What to do when inflation is rising too

much???

• Possible answers:– Fiscal (government intervene: Keynesian)– Classical (do nothing: Laissez-faire)

Fiscal Policy: Keynes

• “The use of government spending and revenue collection to influence the economy” (pg 392) Active Gov!– Target the “G” part of GDP (expenditure

approach) via direct spending– Target the “C” and/or “I” part of GDP

(expenditure approach) by adjusting the “Y” (income approach) through changing tax levels–A little of both

Policy Basics: Expansion & Contraction

• Expansionary Policy–Used when economy is slow (recession)–Goal: increase output: Grow AD

• Contractionary Policy–Used when economy is growing too fast

(peak of cycle)–Goal: Decrease output: shrink AD

Fiscal Basic Intro

Expansionary Policy

Three methods:1. Increase spending (GDP = C + I + G + Xn)

2. Decrease taxes (GDP = Y: Tax decrease increases income, thus C & I spending goes up: AD = C + I + G + Xn)

3. Some combination of both

Open your textbook…

Look at page 395• Figure 15.2 (the left side) shows the process

Contractionary PolicyThree methods:1. Decrease spending (GDP = C + I + G + Nx)

2. Increase taxes (GDP = Y: Tax increase decreases income, thus C & I spending goes down: AD = C + I + G + Nx)

3. Some combination of both

Open your textbook…

Refer to page 396• Figure 15.3 shows the process

Your TurnOpen your books to page 396 (Sullivan text)

Read pages 396-398: answer the following question on your own paper.

There are five basic reasons why fiscal policy is often “clumsy and difficult to put into practice.” Provide a thorough explanation of each one. Make sure to include key terms, examples, and major points of interest.a. Difficulty of changing spending levelsb. Predicting the futurec. Delayed Results d. Political Pressurese. Coordinating Fiscal Policy

Automatic Stabilizers

• Automatic Stabilizers– Items that ‘kick in’ automatically–No need of congressional action– Examples: • Welfare• Food Stamps

• Automatic Stabilizers are forms of government spending

When the economy slows• Government revenue is down (fewer

taxes collected due to decline in production levels)• Due to Automatic Stabilizers,

government spending is up

• This results in budget deficits!!!

Multiplier Effect• Spending ‘multiplies’Think about people’s income: Do they spend

everything? Or do they save some?• MPC = Marginal Propensity to Consume

(Spend)• MPS = Marginal Propensity to Save (Save)

MPC + MPS = 100 % of incomeMPC + MPS = 1

• Take what people spend (MPC) and that expenditure becomes someone else’s income

• That person saves some of their income (MPS) and spends some of it (MPC)

• What that person spends becomes yet another person’s income…–And so on…–And so on…

• Add up all the levels of spending and you will find that the total amount spend has multiplied!!!

The government spends $ 100 to buy some furniture from Fred

Fred saves 10 % of the $ 100.00 and Spends 90 % (spends $ 90) to buy a Radio from Debbie

Debbie saves 10 % of the $ 90 and Spends 90 % (spends $ 81) to buy a necklace from Sarah

So far, a total of $ 271 has been spend on goods & services!!!

And so on…

Assume the MPC = .9(90 % of income will be spent)

Thus, when the government spends, it must consider the multiplier effect or else it could spend too much and spiral

us into inflation!!!

Assume: The MPC is .75Multiplier = 1/MPS

MPC + MPS = 11 – MPC = MPS

If the MPC = .75, then the MPS = .25

Assume: The GDP Gap is $4 BillionThen whatever the government spends will grow by a factor

of 4! Thus the Government wants to increase spending by $1 Billion!1/.25 = 4

YOUR TURN!!!

Open your books to page 391 (Sullivan text)

Read pages 391-394: answer the following questions on your own paper.

1. How much does the government spend on a daily basis?

2. What shapes the government’s taxing and spending decisions?

3. What is fiscal policy used for?

4. What is the federal budget?5. What are the months in our fiscal year (from when

to when)?6. How long does it take to prepare the fiscal budget?7. There are four basic steps in the federal budget

process. Provide a thorough explanation of each step. Make sure to include key terms, date deadlines, and major points of interest.a. Write Spending Proposalb. Create the budgetc. Congressional debate d. On to the White House

Crowding Out Effect