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Fiscal policy keynesians

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Discretionary Fiscal Policy (cont'd)Fiscal PolicyThe discretionary changing of government expenditures or taxes to achieve national economic goals, such as high employment with price stability4Discretionary Fiscal Policy (cont'd)An increase in government spending will stimulate economic activityChanges in government spendingMilitary spendingEducation spendingBudgets for government agencies5Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (a)

If there is a recessionary gap in panel (a), fiscal policy can presumably increase aggregate demand6Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (b)

If there is an inflationary gap, fiscal policy can presumably decrease aggregate demand7Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (a)

In panel (a), the economy is initially at E1, where real GDP exceeds long-run equilibriumContractionary fiscal policy can move aggregate demand to AD2 via a tax increaseA new equilibrium is at E2 at a lower price levelReal GDP is now consistent with LRAS 8Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (b)

In panel (b) with a recessionary gap (in this case $500 billion) taxes are cutAD1 moves to AD2The economy moves from E1 to E2, and real GDP is now at $12 trillion per yearWe are at the long-run equilibrium level 9Discretionary Fiscal Policy (cont'd)Change in taxesA rise in taxes causes a reduction in aggregate demand because it can reduce consumption spending, investment expenditures, and net exports.10Possible Offsets to Fiscal PolicyFiscal policy does not operate in a vacuum and important questions must be answered.How are expenditures financed and by whom?If taxes are increased what does government do with the taxes?What will happen if individuals worry about increases in future taxes?11Possible Offsets to Fiscal Policy (cont'd)Crowding-Out EffectThe tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption in the private sector; this decrease normally results from the rise of interest rates.12The Crowding-Out Effect, Step by Step

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The Crowding-Out Effect

Expansionary policy causing deficit spending initially shifts from AD1 to AD2Due to crowding out, AD shifts inward to AD3Equilibrium GDPbelow full-employment GDPrecessionary gap14Possible Offsets to Fiscal Policy (cont'd)Planning for the future: the Ricardian equivalence theoremRicardian Equivalence TheoremThe proposition that an increase in the government budget deficit has no effect on aggregate demandThe reason for the offsetPeople anticipate that a larger deficit today will mean higher taxes in the future and adjust their spending accordingly.

15Possible Offsets to Fiscal Policy (cont'd)Direct Expenditure OffsetsActions on the part of the private sector in spending income that offset government fiscal policy actionsAny increase in government spending in an area that competes with the private sector will have some direct expenditure offset.16Possible Offsets to Fiscal Policy (cont'd)The supply-side effects of changes in taxesExpansionary fiscal policy could involve reducing marginal tax rates. Advocates argue this increases productivity since individuals will work harder and longer, save more, and invest more.The increased productivity will lead to more economic growth.17Possible Offsets to Fiscal Policy (cont'd)Supply-Side EconomicsThe suggestion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward18

Laffer CurveKhaldun-Laffer curve is a representation of the relationship between possible rates of taxation and the resulting levels of government revenue.Tax rates andtax revenuesrise togetherTax revenues are at a maximumTax rates and tax revenues fall together19Discretionary Fiscal Policy in Practice: Coping with Time LagsRecognition Time LagThe time required to gather information about the current state of the economyAction Time LagThe time required between recognizing an economic problem and putting policy into effectEffect Time LagThe time it takes for a fiscal policy to affect the economy

20Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd)Fiscal policy time lags are long and a policy designed to correct a recession may not produce results until the economy is experiencing inflation.Fiscal policy time lags are variable in length (13 years), and the timing of the desired effect cannot be predicted.Because fiscal policy time lags tend to be variable, policymakers have a difficult time fine-tuning the economy.

21Automatic StabilizersAutomatic or Built-In StabilizersChanges in government spending and taxation that occur automatically without deliberate action of CongressThe tax systemUnemployment compensationWelfare spending22Automatic StabilizersThe automatic changes tend to drive the economy back toward its full-employment output level

23What Do We Really Know About Fiscal Policy?Fiscal policy during normal timesCongress ends up doing too little too late to help in a minor recession.Fiscal policy that generates repeated tax changes (as has happened) creates uncertainty.24What Do We Really Know About Fiscal Policy? (cont'd)Fiscal policy during abnormal timesFiscal policy can be effective The Great Depressionfiscal policy may be able to stimulate aggregate demand.Wartimeduring World War II real GDP increased dramatically.25What Do We Really Know About Fiscal Policy? (cont'd)The soothing effect of Keynesian fiscal policyShould we encounter a severe downturn, fiscal policy is available.Knowing this may reassure consumers and investors.Stable expectations encourage a smoothing of investment spending.26