Fiscal Policy

Fiscal Policy = Changes in the expendetures or tax revenues of the federal government

2 tools of fiscal policy:

- taxes: government can increase or decrease taxes

-spending: government can increase or decrease spending.

-Fiscal Policy is enacted to promote our nations economic goals: Full employment, price stability, economic growth.

Deficits,Surpluses, and Debt

Balanced Budget
-Revenues = expenditures

Budget Deficit
-Revenues< Expenditures

Budget Surplus
-Revenues>Expenditures

FORMULA : Government Debt= Sum of all deficits - Sum of all surpluses

Government borrows from
-Individuals
-Corporations
-Financial Institutions
-Foreign entities or foreign governments

Fiscal Policy, two options

Discretionary fiscal Policy
-Expansionary Fiscal Policy- think deficit
-Constructionary fiscal policy- think surplus

Non-Discretionary fiscal Policy (no action)

Discretionary v Automatic Fiscal Policies

Discretionary : increasing or decreasing government spending and'or taxes in otder to return the conomy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economy problem

Automatic: unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Automatic fiscal policy takes place having to respond to current economic problems.



Expansion fiscal policy:
Increase government spending (G^)
Decrease taxes (T⌄)
Notice that the PL increase. This means expansionary fiscal policy creates some inflation

Contractionary fiscal policy

Decrease government spending (G)
Increase taxes (T^)

Weaknesses of fiscal policy:

Lags
-inside lag: takes time to recognize economic problems and to promote solutions to the problems.
-outside lag: it takes time to implement solution to problem

Supply side policies

Stimulate production supply to spur output

Cut taxes and government regulations to incentives for businesses and individuals.

Businesses invest Ana expands creating jobs people work save and spend more.

Increasing investment and productivity leads to increased output

Demand side policies

Stimulate consumption of goods and services (demand to spur output)

Cut taxes or increase federal spending to put money into people’s hands

With more money People buy more

Businesses increase output to meet growing demand

Automatic or built in stabilizers:

Anything that increases the government budget deficit during a recession and increased its budget surplus without requiring explicit access by policy makers.

Transfer payments:
-welfare checks
-food stamps
-payment checks
-corporate dividends
-social security
-veterans benefits

Tax system 

Progressive tax system
-average tax rate (tax revenue/GDP) rises with GDP

proportional tax system
-average tax rate remains constant as GDP changes

Progressive  tax system
-average tax rates falls within GDP

Consumption and Saving

Disposable Income(DI)
  -income after taxes or net income
2 choices:
-with disposable income households can either
  -consume(spend on goods and services)
  -save(not spend on goods and services.)
Consumption
-Household spending
-Ability to consume is constrained by
  -the amount of disposable income
  -the propensity to save
Do Households consume if DI=0
  -Autonomous consumption

Saving
-Household NOT Spending
-The ability to save is constrained by
  -The amount of disposable income
  -The propensity to consume
Do households save if DI=0?
 no

APC & APS
APC + APS = 1
1 - APC= APS
1 - APS = APC
APC > DISSAVING
-APS DISSAVING

MPC & MPS
marginal propensity to consume
  -△C/△DI
  -% of every extra dollar earned that is spent

marginal propensity to save
 - △S/△DI
 - % of every extra dollar earned that is saved

MPC+MPS=1
1-MPC=MPS
1-MPS=MPC

Marginal propensity to consume

MPC= △ in consumption
           ------------------------
           △ In disposable income

MPS= △ in savings
           -----------------------
           △ in disposable income

The spending multiplier effect
- an initial change in spending (C.IG, G , Xn) causes a larger change in aggregate spending or aggregate demand (AD)

Multiplier= △in AD/ △in spending

Multiplier= △S/△C,Ig,G,Xn

Why does this happen?
-expenditures and income flow continuously which sets off a spending increase in the economy.

Calculating Spending multiplier
-can be calculated from MPC or MPS

Multiplier= 1/1 - MPC  OR  1/MPS

-multipliers are + when theres an increase in spending and - when there is a decrease.

How to calculate tax multiplier
-when government taxes, the multiplier works in reverse.
Why?
- because money is leaving circular flow.
Tax Multiplier (note: its negative)
= -MPC/1 - MPC or -MPC/MPS
If there is a tax CUT then multiplier is + because there's more money in circular flow.

Interest rates and Investment Demand

Investment:Money spent on expendentures on
  -New plants (factories)
  -Capital equipment(machinery)
  -Technology(hardware and software)
  -New homes
  -Inventories(goods sold by producers)

Expected rates of return
-How does business make investment decisions?
  -Cost/benefit analysis
-How does business determine the benefits
  -expected rate of return
-How does business count the cost?
  -interest rates
-How does business determine the amount of investment they undertake?
  -compare expected rate of return to interest cost
  -if expected return＞ interest cost, than invest
  -If expected return＜ interest cost, then don't invest

Real (r%) v. Nominal(i%)
Real is adjusted for inflation
nominal is current

-nominal is the observable rate of interest.
-real subtracts out inflation (n%) and is only known as ex post facto.

Formula for real interest rate (r%)

r%= i% - ℼ%

what determines cost of investment decision
-real interest rate (r%)

Investment Demand Curve (ID)
What is the shape of investment demand curve?
  -Downward sloping
Why?
  -when interest rates are high, fewer investments are profitable; when interests rates are low more investments are profitable
  -Conversely, there are few investments that yield low rates of return

The investment demand curve:

The AS/AD Model

-The equilibrium of AS and AD determines current output (GDPr) and the price level (PL)

Full employment
- full employment equilibrium exists where AD intersects SRAS and LRAS at the same point

Recessionary Gap:
- a recession gap exists when equilibrium occurs below full employment output

Inflationary Gap:
-an inflationary gap occurs when equilibrium occurs beyond full employment output


Keynesian Range :

-recession or depression
-not fully using all your resources
-below the FE

Intermediate : 

-Resources are getting closer to full employment levels which creates upward pressure on wages and prices

Classical or vertical range :

-When real GDP is at a level below the full employment level where any increase in demand will resolve only in an increase in prices.


Demand-Pull Inflation : 

 -An increase in average price level resulting from an increase in total spending
in the economy.

-Total spending = C+Ig+G+Xn
nations AD
- increase in AD

Cost-Push Inflation :Occurs when firms respond to rising costs by increasing their prices to protect profit margins.

caused by

1. Rising unit labor costs

2. Increase in price of raw material/important components

3. Depreciation in exchange rate
causing a rise in import costs

4. An increase in business
taxes ex: VAT or environmental
taxes such as a carbon tax

Factors Affecting Inflationary PressuresRise property prices > Increase consumer wealth > Demand-pull inflation risk

Increase world oil prices > Higher costs for businesses > Cost-push inflation risk

Depreciating exchange rate > Increased import prices + rising exports > Cost-push and Demand-pull risk

The rapid expansion of money and credit from banks > rising consumer spending financed by loans > Demand-pull inflation risk

Aggregate Supply

Aggregate supply- the level of real GDP (GDPr) that firms will produce at each price level (Pl)

Long run vs Short run
Long run
- period of time where input prices are completely flexible and adjust to changes in the price level
-In the long run, the level of Real GDP supplied is independent of the price level.
Short Run
-period of time where input prices are STICKY and do not adjust to changes in price level
-In short run, the level of real GDP supplied is directly related to the price level

Long-Run Aggregate Supply (LRAS)
-the long run Aggregate Supply or LRAS, marks the level of full employment in the economy.
-because input prices are completely flexible in the long run, changes in price- level don not change firms' real profits and therefore do not change firms level of output. This means LRAS is vertical at the economy's level of full employment.

Long Run aggregate Supply Graph


Short Run Aggregate supply (SRAS)
-SRAS is upward sloping

Changes in SRAS
-increase in SRAS is seen as a shift to the right SRAS -->
-decrease in SRAS is seen as a shift to the left. SRAS<--
-The key to understanding shifts in SRAS is per unit cost of production

formula: per unit production cost = total input cost/ total output

Determinants of SRAS
(all of the following affect unit production cost)
-Input prices
-productivity
-Legal- institutional enviroment

Breakdown...

Input prices
-Domestic resource prices
  -wages (75% of business costs)
  -cost of capital
  -raw materials

- foreign resource prices
  -strong $=lower foreign resource prices
  -Weak $= higher foreign resource prices

-Market Power
  -monopolies and cartels that control resources control the price of these resources.

-Increase in resource prices= SRAS<--
-Decrease in resource prices= SRAS-->

Productivity
-productivity= total output/total input
-more productivity=lower unit production cost=SRAS-->
lower productivity= higher unit production cost=SRAS<--

Legal Institutional enviroment
-Taxes and subsidies
  taxes($ to government) on business increase per unit production cost= SRAS<--
-Government Regulation
  -Government regulation creates a cost of compliance SRAS<--
  Deregulation reduces compliance costs SRAS-->