Fiscal Policy

By: Johnny, Faisal, Nish, Bianca, &

Kalam

Welcome to Day 1!

The Goal of Stabilization:• Influence the amount spent and produced in an economy• Meant to meet potential output• To have less movements in the business cycle

Fiscal Policy

Use of Fiscal Policy:• Two Policies : Expansionary Policies and

Contractionary Policies are used to control output• Injections and withdrawals helps or takes away from the

circular flow• Governments effects aggregate demand and aggregate

supply

• Government purchases have immediate effect on aggregate demand while tax cuts are less immediate

Automatic Stabilizers:• Discretionary policies are intentional government intervention

in the economy• Automatic stabilizers are built-in measures that lessen the

effects of the business cycle• Examples are taxation and transfer payment programs

Introduction to The Spending Multiplier:

• The impact policies have on the economy is like a ripple effect

• Assuming that price is constant, multiplier effect is the magnified impact of a spending change on aggregate demand

• Marginal Propensity to Consume answers the question: “If income increases this amount, how much extra will be spent on domestic goods and services?”

•MPC = change in consumption on domestic items

change in income

Marginal Propensity to Withdraw is the effect on withdrawals of a change in income

MPW = change in total withdraws

change in income

END OF DAY 1!Have a fabulous day

Day 2: The Spending Multiplier

The Multiplier Effect

• Government decision-makers estimate the impact of their policies on the economy by using the multiplier effect

• Multiplier Effect: the magnified impact of a spending change on aggregate demand

500 250

Spender A ------> Spender B ------> Spender C ------>

Increase in Income: (1000) (500) (250)

• Marginal Propensity to Consume (MPC): the effect on domestic consumption of a change in income

• MPC answers the question: “If income increases this amount, how much extra will be spent on domestic goods and services?”

MPC= change in consumption on domestic items ------------------------------------------------------

change in income

• Marginal Propensity to Withdraw (MPW): the effect on withdrawals of a change in income

• 3 types of withdrawals: savings, taxes, and importsMPW= change in total withdrawals

------------------------------------ change in income

• 1.0 = MPC + MPW

Multiplier Effect in Detail

1st Round: Government pays Spender A $1000 Real Output: 1000

(not only income, but also economy’s output)

2nd Round: MPC is 0.5 (500/1000) MPW is also (500/1000) MPC=$500 MPW=$500 Real

Output: 1500

3rd Round: Spender B MPC=$250 MPW=$250 Real

Output: 1750

Later Spending Rounds:Total MPC Total MPW Real

Output: 2000 for later spending rounds for later spending rounds

=$250 =$250

• Expansion continues until withdrawals equal initial discretionary injection• Injections and withdrawals are both $1000 higher than they

were before government purchases were increased

The Spending Multiplier• Spending multiplier is the value by which the initial spending change is multiplied to give the total change in output• Total Change = initial change X spending in spending in spending multiplier• recall that the economy’s total output expands until new withdrawals equal the initial government purchase• There is an inverse relationship between MPW and the spending multiplier ( if MPW is ½, then the multiplier equals 2) therefore spending multiplier is the reciprocal of the MPW

• The multiplier effect can also be applied to tax cuts• Lower taxes allow others to have more funds to

spend and invest and therefore in this case the spending multiplier is multiplied with the initial spending from the tax cut

• Increases the total output and shifts aggregate demand curve

• Tax adjustment has a small initial effect on spending

• Since aggregate supply curve gets steeper as it reaches the potential output level, an increase in equilibrium makes the price level rise proportionally more than output

• When economy is above its potential, both price level and total output falls; price will fall proportionally more than output

•Multiplier effect is useful in indicating the maximum change in equilibrium output following a certain fiscal policy

Benefits of Fiscal Policy• Two benefits as a stabilization tool: its regional

focus, and the direct impact it has on spending• Regional Focus:

• Parts of Canada may be more affected than others by the business cycle

• Discretionary fiscal policy can focus on particular regions where, for example, unemployment rates are the highest or inflation is at its worst

• Automatic stabilizers have the greatest effect in regions that need them the most

• Impact on Spending:• Fiscal policy has a more straightforward impact when

altering government purchases than monetary policy, since the government itself initiates the change

Drawbacks of Fiscal Policy

• Delays:• Recognition Lag – the amount of time it takes policy-makers

to realize that a policy is needed• Decision Lag – the amount of time needed to formulate and

implement an appropriate policy• Impact Lag – the amount of time between a policy’s

implementation and its having an effect on the economy• Political Visibility:

• Voters are likely to respond more favourably to increases in government purchases and cuts in taxes

• Public Debt:• Public Debt - the total amount owed by the federal

government as a result of its past borrowing• Public Debt Charges – are the amounts paid out each year

by the federal government to cover the interest charges on its public debt

End of Day 2

Day 3: Impact of Fiscal Policy

Impact of Fiscal Policy

• Balanced budget is the situation where a government’s expenditure and revenues are equal

• A budget surplus is when a government’s revenues exceed expenditures

• A budget deficit is when a government’s expenditure exceeds revenues

• Size of a government’s surplus or deficit in relation to the economy’s overall GDP gives clues to what type of discretionary fiscal policy in operation, as well as the automatic stabilizers

• Rarely does budget surpluses relate to discretionary fiscal policy. (Example of such would be the government deciding to suppress the inflationary effects of an economic boom by raising income taxes and cutting defense spending

• Budget surpluses are more likely because of built in factors (rising tax revenues might outweigh transfer payment can show a surplus during economic booms)

• Budget deficits may indicate active expansionary policies that increase government expenditures and reduce revenues

• Budget deficits occur often as a result of automatic stabilizers (example: les jobs and spending during a recession leads to rising Unemployment Insurance and sagging income tax revenues)

Budget Surpluses and Deficits

Fiscal Policy Guidelines

• 3 principles that guide government fiscal policy:1) Annually balanced budgets 2) Cyclically balanced budgets

3) Functional finance• Annually balanced budget is the principle that

government revenues and expenditures should balanced each year

• Critics of fiscal policy say annually balanced budget are not necessary for the society and state it as faulty reasoning

• Cyclically balanced budget is the principle that government revenues and expenditures should balanced over the course of one business cycle

Recent Fiscal Policy• Government revenues and expenditures don’t need to balance

every year but over one business cycle• Function finance is the principle that government budgets

should be geared to the yearly needs of the economy• Defenders of functional finance are those who believe fiscal

policy is a powerful stabilization took• The choice of fiscal policy guideline depends on the

government’s belief in fiscal policy as an effective took for stabilizing the economy

• 1970s and 1980s Canada believed in functional finance but recently has made unsuccessful attempts to move toward cyclically balanced budgets

• Canada’s change of view came from constant budget deficits and its impact on the economy as a whole

• Government deficits were highest during recessions during the early 1980s and early 1990s

• Tax revenues fell with slumping incomes during that time as a result of the automatic stabilizers

• Discretionary expansionary policy also contributed since federal government increased purchases of goods and services to counteract the effects of sagging outputs and incomes

• Canada experienced a period of economic growth, noticeably during 1988 where unemployment was under 8%, the economy was at or above potential output but still budgets didn’t show a surplus

• 1990s downturn caused a concern over increased public debt and lowered confidence in discretionary fiscal policies to counteract a recession

End of Day 3