Understanding Fiscal and Stabilization Policies for Economic Stability

Understanding Fiscal and Stabilization Policies for Economic Stability

Learn about expansionary and contractionary fiscal policies, multiplier effect, budget surpluses/deficits, and stabilization policies for economic stability.

About Understanding Fiscal and Stabilization Policies for Economic Stability

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1. present by : Ivy, Yi Lin, Mamie, Mon, Chris

2. you will: 1. learn about expansionary and contractionary fiscal policies, which are used by governments seeking economic stability 2. analyze the multiplier effect of fiscal policy, as determined by the marginal propensities to consumer and withdraw 3. consider budget surpluses and deficits and their impact on public debt and public debt charges

3. Stabilization policy is government policy designed to lessen the effects of the business cycle which can be either expansionary policies or contractionary policies. expansionary policies attempt to reduce unemployment and stimulate total output contractionary policies attempt to stabilize prices and bring the economy back down to its potential output.

4. CONTRACTION EXPANSION Peak Trough Long-Run Trend of Potential Output Without stabilization policy With stabilization policy Real GDP Time

5. Governments have an extensive impact on the economy through texation and government purchases.

6. Fiscal Policy uses taxes and government purchases as its tools Fiscal Year is the 12-month period to which a budget applies Monetary policy uses interest rates and the money supply as its tool.

7. Expansionary fiscal policy involves increasing government purchases, decreasing taxes, or both to stimulate spending and output. Contractionary fiscal policy involves decreasing government purchases, increasing taxes, or both to restrain spending and output.

8. expansionary fiscal policy involves more government purchases and/or lower taxes to shift AD rightward AS AD 0 AD 1 b a Potential Output Initial Recessionary Gap Real GDP (1997 $ billions) 800 780 0 170 160 Price Level (GDP deflator, 1997 = 100)

9. contractionary fiscal policy involves fewer government purchases and/or increased taxes to shift AD leftward 810 800 0 190 170 Real GDP (1997 $ billions) Price Level (GDP deflator, 1997 = 100) AS AD 0 AD 1 Potential Output Initial Inflationary Gap d c

10. Discretionary Policy is international government intervention in the economy such as bedgeted changes in spending or texation. Automatic stabilizers: built-in measures, such as texation&transfer payment programs, that lessen the effects of the business cycle. Net tax revenues = taxes collected transfers&subsidies

11. The magnified impact of a spending change on aggregate demand an initial spending change produces income and part of this new income becomes new spending The process is repeated with each spending round smaller than the last Each new spending round are determined by the marginal propensity to consumer(MPC) and marginal propensity

12. Marginal propensity to consumer (MPC) the effect on domestic consumption of a change in income MPC = change in consumption on domestic items change in income Marginal propensity to withdraw (MPW) the effect on withdrawals saving , imports , and taxes of a change in income MPW = change in total withdrawals change in income *MPC + MPW = 1 income is always either spend or withdrawn

13. Exercise: A $100 increase in a person's income causes him to increase his saving by $5, his imports by $35, and his tax payments by $20. In this case, the marginal propensity to withdraw is: Change in total withdrawals(saving/ import/ taxes) Change in income 5 + 35 + 20 = 60 = 0.6 100 100

14. The multiplier effect will continue until withdrawals equal to the initial discretionary injection

15. The spending multiplier is the value by which the initial spending change is multiplied to give the total change in real output. In other words, the shift in the aggregate demand curve Total change in output = initial change x spending (shift in AD curve) in spending multiplier

16. Example: Find the spending multiplier when initial spend has rose by $1000 and the total output increased by $2000. Spending multiplier= total change in output Initial change in spending = $2000 $1000 =2

17. Relationship between the marginal propensity to withdraw and the spending multiplier The spending multiplier is the reciprocal of the marginal propensity to withdraw. Example: If MPW (marginal propensity to withdraw) is 0.5 what is the spending multiplier? Spending Multiplier = __1__ MPW = _1_ 0.5 =2

18. Effect of a Tax Cut The multiplier effect can be applied to tax cuts Tax cuts can be used to expand the economy Lower tax cuts can leave households and businesses with more funds to spend and invest The initial spending stimulus of the tax cut is multiplied by the spending multiplier (or reciprocal of MPW). This results in an increase in total output a shift in the aggregate demand curve

19. The initial change in spending on domestic items from a change in taxes (T) is found by multiplying the economy s marginal propensity to consume by the size of the tax change, then it is multiplied by the spending multiplier (1/MPA) Total change in output = initial change x spending (shift in AD curve) in spending multiplier -(MPC X T) has a minus sign because the spending change is in the opposite direction to the tax change Total change in output = - (MPC X change in T) x (1/MPA)

20. Relevance of the Spending Multiplier When the economy is close to its potential level, the increase in aggregate demand translates into higher price levels more than into expanded production When the stated goal being a stable economy and expanded output, expansionary fiscal policy is less effective the closer the economy is to its potential Similarly, for the contractionary fiscal policy, when the economy is above its potential, a decrease in aggregate demand means both price level and total output will fall Based on the possible changes in the price level, the multiplier effect is less definite than the use of simple formula would indicate

21. Two benefit s as stabilization tool: regional focus and impact on spending Regional focus it can be focused on particular regions During a recession, new government purchases and program to reduce the amount of tax paid can be targeted to regions where unemployment rate are highest . Net income revenue drop hit by unemployment and falling output. In a boom, spending cuts and tax hikes can be concentrated on the regions where inflation is at its worst. Larger increase in net tax revenue in regional where the economy is most over-heated. 10/22/2014

22. Impact on spending it has a relatively direct impact on spending compare with monetary policy--Fiscal policy is easy to control the trend of economy, making it closer the potential output and achieve the goal of stabilization) influences of a stabilization is tied to its initial effect on spending During recession, government increase the government purchases, it decrease the spending In contrast, government decreases the government purchases which increase the spendingalter the government purchases to make economy stability. 10/22/2014

23. a)Delays while automatic stabilizers to stabilize the economy, the discretionary measure are sometimes delayed. Recognition lag : the amount of time it takes policy-makers to realize that a policy needed.( decided and realized the economy need adjusted ) Decision lag : t he amount of time needed to formulate and implement an appropriate policy.(how to adjust) Impact lag: the amount of time between a policys implementation and its having an effect on the economy.(already have move to a different point in the business cycle ) 10/22/2014

24. b)Political visibility Discretionary is highly visible element of government activity, therefore, it is often affected by political and economic considerations. E.G vote: increases in government purchases and reduce the taxes, regardless of the appropriateness of these policies for the economy.(election is coming up) 10/22/2014

25. c)Public debt Public debt: the total amount owned by the federal government as a result of its past borrowing. Total government: include the debts of individuals provinces and territories and incorporates local government and hospital. Public debt charges : the amounts paid out each year by the federal government to cover the interest charges on its public debt. E.G. the federal governments public charge were37.2billion, the government should pay 507.7 to bondholders. What is the average interest? Average interest rate=public debt charge/public debt 10/22/2014

26. Balanced budget mean governments expenditures and revenues are equal This situation is so uncommon. 10/22/2014 Balanced budget

27. Budget surplus is the governments revenues exceed its expenditures government revenues- government expenditures = Budget surplus For example, government will cut defence spending and raising income taxes during the economic boom to suppress the inflationary. 10/22/2014

28. Budget deficit is the governments expenditures exceed its revenues government expenditure government revenue=Budget deficit For example, government will increase the spending on road and bridges, or institute a temporary sales-tax cut to stimulate household spending, during the downturn. 10/22/2014

29. The governments debt represents the sum of all its past budget deficits minus any budget surpluses. Budget deficits- Budget surpluses = governments debt When the government has a budget surplus, the the public debt reduced by the same amount. When the government has a budget deficit, the public debt increases by the same amount. 10/22/2014

30. There are 3 principles that guide government fiscal policy: 1 Annually balanced budgets 2 Cyclically balanced budgets 3 Functional Finance Critics of fiscal policy suggest that any fiscal policy that is used must be guided by the principle of an annually balanced budget. In other words, revenues and expenditures should be balanced every year. Critics also say that an annually balanced budget is not necessarily appropriate for society and state it is flawed reasoning. Cyclically balanced budget is the principle that government revenues and expenditures should balance over the course of one business cycle. 10/22/2014

31. Functional Finance is the principle that government budgets should be geared to the yearly needs of the economy. The choice of fiscal policy guidelines depends on the governments belief in fiscal policy as an effective tool for stabilizing the economy. Defenders of functional finance are those who see functional finance as a powerful stabilizing tool, while economist who support cyclically or annually balanced budget tend to be less convinced of fiscal policys effectiveness. 10/22/2014

32. In the 1970s and early 1980s, Canada believed in functional finance but recently had made unsuccessful attempts to move towards cyclically balanced budgets. This change in view came from constant budget deficits and their impact on the economy as a whole. Total government deficits were highest during the recessions in early 1980s and 1990s. The 1980s deficits were largely optional, while the 1990s deficits were related to automatic stabilizers. 10/22/2014

33. Neoclassical theory is the view of economy that economic slow-downs such as the great depression were self correcting and is based on two assumptions: flexible labour markets and Says law. Flexible labour markets: Neoclassical economists suggest that both the demand and supply of labour depend on real wage rate, or wages expressed in constant base-year dollars, rather than the nominal wage rate, which is valued in current dollars. There are two types of unemployment: 1 Voluntary unemployment 2 Involuntary unemployment Voluntary unemployment exists whenever workers decide that real wages are not high enough to make work worthwhile. Involuntary unemployment is when someone wants to work at the current real wage rate but cannot find a job. Involuntary occurs when the market demand and supply creates a surplus. 10/22/2014

34. Say argued that supply automatically creates its own demand. An example would be a tailor supplies clothes in order to have funds needed to purchase other products. Keyness theory challenged both assumptions made by the neoclassical economists. Keynes believed that workers are influenced by nominal wages rather than real wages and purchasing power. 10/22/2014

35. 10/22/2014