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FISCAL POLICY
Fiscal Policy
Gov. can affect AD through G or T
Directly: increase or decrease G, AD shifts
Indirectly: increase or decrease T and C and I will change, which will shift AD
Fiscal Policy
What’s the difference between actual and full employment?
Draw an economy with a recessionary gap.
Fiscal Policy Expansionary Fiscal Policy When AD is too low, the
economy is not at full employment (or potential GDP)
Fiscal policy is expansionary to increase AD by increasing spending and/or reducing taxes
moves the economy toward full employment
Fiscal Policy Expansionary policy increases
employment, but can raise price levelResult in budget deficits
Fiscal Policy Draw an economy in with an
inflationary gap.
Fiscal Policy Contractionary Policies If the level of AD is too high, it
creates inflationary pressures. Fiscal policy is contractionary Reduce taxes and/or decrease
spending Moves economy to full
employment
Fiscal Policy Contractionary policies can
reduce inflationary pressures, butCan reduce outputReduce employment levelCan also result in budget surpluses ( or smaller deficits)
Fiscal Policy
The multiplier effectTax multiplierAlways negativeMPC/ (1-MPC)Same as MPC/MPSAny change in taxes has a
greater effect on C and/or I
Fiscal Policy The multiplier effect The spending multiplier 1/(1-MPC) Same as 1/MPS Any change in government
spending has a greater effect than the amount of the spending
Fiscal Policy Because of the multiplier effect
the change in G or T to close a recessionary or inflationary gap (between the actual equilibrium level and the full employment level of output) will be smaller than the gap.
Change in G or T multiplied by the multiplier should equal the size of the gap.
Fiscal Policy Discretionary Fiscal
Policy When the government chooses
to change G or T, at the discretion of Congress and the president.
Fiscal Policy Automatic Fiscal Policy Policies that work to stabilize the
economy through changes that happen automatically.No one needs to make a decision
about these; a system is already in place.
Progressive income tax, unemployment, income based-transfer payments,
Policy Effects on Aggregate Supply
Any policy that changes a determinant of of SRAS will affect the macroeconomy through the supply side.
What are the determinants of SRAS?
Policy Effects on Aggregate Supply
Determinants of SRAS ( things that will shift the SRAS):Economy wide input prices (like
wages and energy prices)Productivity
Factors that affect LRAS:Increase in available resourcesHigher quality resourcesTechnological advances
Policy Effects on Aggregate Supply
Draw 2 correctly labeled AS/AD graphs.
Show the effect of the following on eq. price and RGDP:Graph 1 increase in ADGraph 2 increase in AS
What are the differences in the results for graph 1 and 2?
Policy Effects on Aggregate Supply
Goals of Monetary and Fiscal policyEconomic growthFull employmentPrice stability
Policy Effects on Aggregate Supply
How might a shift in AS move the economy toward the main goals?
What might cause such a shift?
Policy Effects on Aggregate Supply
AD 1
LRAS
SRAS
AD
Price Level
RGDP
PL
PL1
Y* Y1
• Suppose the Fed increases the MS:
• Interest rates decrease
• Investment and interest sensitive consumption increases
• Increase in AD• Output increases• PL increases
Policy Effects on Aggregate Supply
AD1
LRAS
SRAS
AD
Price Level
RGDP
PL
PL1
Y* Y1
• New short run equilibrium has output above the full employment level.
• As a result, nominal wages will rise (the demand for more workers to increase output allows workers to bargain for higher wages.
Policy Effects on Aggregate Supply
AD1
LRAS
SRAS
AD
Price Level
RGDP
PLPL1
Y* Y1
• The higher wages lead to a leftward shift of the AS .
• New long run-equilibrium at full-employment level
• Higher price level• In the long run,
increase in MS has NOT changed RGDP, only increase in PL.
SRAS1
PL2
Policy Effects on Aggregate Supply
SRAS 1
LRAS
SRAS
AD
Price Level
RGDP
PL
PL1
Y* Y1
