Fiscal Policy, Income and expenditures equilibrium

Reaganomics: Results

"Supply siders" argued that the incentive effects were so large that a reduction in tax rates would actually raise tax revenue, since the tax base would grow so much. There's no sign that this happened. Quite to the contrary, the budget deficits exploded in the 1980s after tax rates were cut by Reagan in 1981. The response of private savings and labor supply to the Reagan tax cuts was minimal: the labor supply did not increase and the effect on private savings was swamped by the reduction in public savings (the increase in the budget deficit). Since labor supply and savings increased only marginally, government revenues did not increase (relative to GDP) and the budget deficit became very large. The Laffer curve hypothesis was was flatly contradicted. Moreover, the 1980s tax cuts did not increase the rate of growth of GDP and productivity, nor the investment and savings rates.

Suppose the government of Schoeneville wants to finance a $1 million increase in government spending by raising taxes. The tax increase decreases total consumers' disposable incomes by $___________ million. If consumer spending changes by 80% of the change in consumers' income, then the net effect of the increase in government spending will be a ___________ in aggregate expenditure.

$1/$0.2 million increase Total aggregate expenditures are equal to the sum of consumption, investment, government spending, and net exports. If the spending is financed by increasing taxes, then consumers have a total of $1 million less in disposable income (remember that disposable income is equal to net income minus taxes). If consumer spending changes by 80% of the change in consumers' income, then a $1 million decrease in disposable income will reduce consumer spending by $0.8 million. The net effect of the increase in government spending and decrease in consumer spending is, therefore, $1 million - $0.8 million = $0.2 million increase in aggregate expenditure.

(P3A)The following graph shows the consumption function (C) for a hypothetical private closed economy and a 45-degree line along which aggregate expenditure equals real GDP (AE=Y). Recall that a private closed economy does not have government and does not trade with the rest of the world (so G=0 and (X-M)=0). In a private closed economy, real GDP is equal to disposable income. At the current real interest rate, the level of investment in this economy is equal to $75 billion at each level of real GDP. Use the blue line (circle symbols) to plot this economy's initial aggregate expenditure line, (C + I). Then, use the black point (X symbol) to indicate this economy's initial equilibrium output. Dashed drop lines will automatically extend to both axes. (Hint: You can see two of the coordinates along the consumption function by moussing over the green triangles on the graph.) At the level of equilibrium output you just indicated, the level of saving is equal to_________ . At an output level of $600 billion, aggregate expenditure will be __________ (equal to, greater than, less than) real GDP and firms will experience ____________ (an unplanned decrease, no change, an unplanned increase) in business inventories. Firms will respond to this situation by: (Decreasing production, Leaving production unchanged, Increasing production) At an output level of $650 billion, aggregate expenditure will be __________ (equal to, greater than, less than) real GDP and firms will experience ____________ (an unplanned decrease, no change, an unplanned increase) in business inventories. Firms will respond to this situation by: (Decreasing production, Leaving production unchanged, Increasing production)

$75 billion greater than/an unplanned decrease/Increasing production equal to/no change/Leaving production unchanged

Problems for fiscal policymakers

- Approximately 2/3 of federal spending cannot be cut for legal or political reasons. - Most politicians do not want to commit career suicide by raising taxes. - Continual deficits raise serious long-term risks in regards to future mandatory budget spending and out national debt.

Long-Term Risks

- Inflation of U.S. Dollar - Foreign investors will demand higher interest - Mandatory spending will exceed tax revenue - Increasing dependence on foreign sources of funding will render the U.S. less able to act independently. - Some economists state simply our only 3 options are: - 1)Bankruptcy 2)Cutting payouts 3) Raising Taxes.

Fiscal vs. Monetary policy

- Manipulating the federal budget (fiscal) - Regulate rate of growth of money supply (monetary)

(P2A)Suppose the following table shows consumption (CC), investment (II), government purchases (GG), and net exports (NXNX) in a hypothetical economy for various levels of real GDP. Assume that the price level remains unchanged at all levels of real GDP. 1) Calculate AE (C + I + G + NX) 2) What is the equilibrium? (blank = blank)

1) 650, 675, 700, 725, 750 2) AE = 700/ GDP = 700

(P1A)Suppose the following table shows consumption (CC), investment (II), government purchases (GG), and net exports (NXNX) in a hypothetical economy for various levels of real GDP. Assume that the price level remains unchanged at all levels of real GDP. 1) Calculate AE (C + I + G + NX) 2) What is the equilibrium? (blank = blank)

1) 650, 700, 750, 800, 850 2) AE = 800/ GDP = 800

(Problem 1B) In which years was the government's budget in deficit? Check all that apply. 1948 1956 1964 1972 1980 (When exp is higher than rev) exp - rev = national debt In 1964, the national debt _________ by _________.

1964 1972 1980 increased/$5.9 billion

(P3B) Suppose the real interest rate falls and the level of investment in this economy increases by $50 billion. Use the blue line (circle symbols) to show the economy's aggregate expenditure line, (C + I), after the increase in investment. Then use the gray point (star symbol) to show the economy's new equilibrium output. Dashed drop lines will extend to both axes. Hint: Start with your aggregate expenditure line from the previous graph. Make sure the slope of the aggregate expenditure line is the same as the previous aggregate expenditure line you just plotted. You can check the slope of the line by clicking on the line after you plot it. The simple spending multiplier for this private closed economy is____ . (Simple spending multiplier)

2

Which of the following are examples of automatic stabilizers? Check all that apply. 1) In 2001, partly in response to a recession, Congress enacted lower income tax rates and increased tax exemptions for married couples. 2) As people earn higher incomes during an expansion, the progressive tax system requires them to pay higher average tax rates. 3) As corporate profits rise during an economic expansion, corporate income tax revenues rise. 4) In response to the 1981-82 recession, the U.S. government passed a law that lowered personal income tax rates.

2) As people earn higher incomes during an expansion, the progressive tax system requires them to pay higher average tax rates. 3) As corporate profits rise during an economic expansion, corporate income tax revenues rise. Automatic stabilizers are government taxes and transfers that automatically temper recessions and expansions without any explicit action by lawmakers. Automatic stabilizers increase the government's budget deficit (or reduce its surplus) during recessions and increase the government's budget surplus (or reduce its deficit) during expansions.

Which of the following are examples of automatic stabilizers? Check all that apply. 1) In response to the 2008 recession, Congress approved billions of dollars of additional spending on public infrastructure projects. 2) As unemployment falls during an expansion, unemployment insurance payments decline. 3) In 1968, Congress enacted a temporary 10% increase in personal income tax rates in response to an inflationary GDP gap. 4) As people earn higher incomes during an expansion, the progressive tax system requires them to pay higher average tax rates.

2) As unemployment falls during an expansion, unemployment insurance payments decline. 4) As people earn higher incomes during an expansion, the progressive tax system requires them to pay higher average tax rates. Automatic stabilizers are government taxes and transfers that automatically temper recessions and expansions without any explicit action by lawmakers. Automatic stabilizers increase the government's budget deficit (or reduce its surplus) during recessions and increase the government's budget surplus (or reduce its deficit) during expansions.

(P1B) What is looks like on graph Suppose real GDP is currently $500 billion. Assuming that the price level remains constant, this would mean that_____________ , which would send a signal to firms to___________. Look at the graph what does the GDP pair with on AE?

500 - 650 = -150 firms would experience a $150 billion reduction in inventories/increase production

(P2B) What is looks like on graph Suppose real GDP is currently $900 billion. Assuming that the price level remains constant, this would mean that_____________ , which would send a signal to firms to___________. Look at the graph what does the GDP pair with on AE?

900 - 750 = 150 firms would have excess inventories of $150 billion / decrease production

AE and changes in price levels

Aggregate expenditures curve will shift when the price level changes because of the wealth effect, interest rate effect, and the international trade effect. The changing price levels which shift the AE curve will allow us to derive our aggregate demand curve.

Discretionary fiscal policy in practice: time lags

Although fiscal policymakers can use aggregate demand and supply to explain what they are doing, they still have to deal with the problem of time lags. - Recognition time lags - Action time lags - Effect time lags

Fiscal policy in the U.S

An intricate process that involves both the executive and legislative branches of govt. - U.S Fiscal year: - October 1 - September 30 - The budget process begins in the spring - Lasts appx 18 months

(S3A) The spending multiplier

Any change in autonomous expenditures is multiplied in to a larger change in equilibrium real GDP. In other words, if autonomous expenditures increase by $1, equilibrium real GDP increase by more than a dollar.

(S3B) The spending multiplier example

Any change in autonomous expenditures is multiplied in to a larger change in equilibrium real GDP. In other words, if autonomous expenditures increase by $1, equilibrium real GDP increase by more than a dollar. MPC - MPI = Another round of spending Change in income * Another round of spending = change in income This would take to long use the spending multiplier

(S2A) When AE is less than Real GDP, Real GDP falls

As inventories increase firms will cut back production of goods and services. This will cause real GDP to fall. Thus, when AE is less than real GDP, real GDP falls.

(S2B) When AE is less than Real GDP, Real GDP falls

As inventories increase firms will cut back production of goods and services. This will cause real GDP to fall. Thus, when AE is less than real GDP, real GDP falls.

Automatic Stabilizers

Automatic stabilizers are designed to partially offset changes in income so that fluctuations in the business cycle are restrained (diminish the impact of the business cycle). Examples: Progressive Income Taxes Transfer Payments

Keynesian SRAS curve answers only

Because Keynesians believe that prices are fixed in the region of the supply curve leading up to potential GDP, their conception of aggregate supply is best represented by the curve labeled ASb. You can see that if prices are increasing in the region leading up to potential output, the shift in aggregate demand needed to restore potential GDP is greater than if the price level remains constant in this region. Because it is unrealistic that prices will not rise along with expenditures in this region, the Keynesian model underestimates the amount of new spending necessary to restore potential output.

Keynes viewpoint

Believed an economy could come to rest at a level of GDP that was too low to offer employment for the entire labor force. Keynes believed the government should intervene by pumping money back into the economy to stimulate income and output.

Discretionary fiscal policy

Can be viewed as the deliberate, discretionary changes in government expenditures or taxes to achieve national economic goals. Goals (examples) - High employment - Price Stability - Eliminating GDP Gap

Shifting the AD Curve

Changes in government spending and taxes will shift the aggregate demand curve. Which direction will the AD curve shift if the government increases spending on goods and services? How does this affect real GDP & equilibrium price levels in the economy? Which direction will the AD curve shift if the government lowers taxes?

Multiplier Effect

Changes in government spending may also have a multiplier effect on real GDP. In other words, initially, a change of $1 in govt. spending will increase/decrease real GDP by a $1. Eventually (as we learned in Chapter 10) that $1 would "multiply" in the economy, having a much larger impact on real GDP than the initial $1.

Answer only

Consider the investment demand (ID) curve on the following graph. Initially, the interest rate is 3% and the quantity of investment demanded is $570 billion. Suppose an increase in the public debt causes the interest rate to rise from 3% to 5%. The increase in the public debt crowds out $10 billion of private investment. (Assume that the increase in the public debt does not affect the position of the investment demand curve.) If the interest rate rises from 3% to 5%, there is a movement up and along the investment demand curve. The quantity of investment demanded declines from $570 billion to $560 billion. That is, the increase in the public debt crowds out $10 billion of private investment spending. An increase in the public debt tends to increase the real interest rate and crowd out private investment. By using additional public debt to finance public investments that are complements to private investment, the government can reduce the size of the crowding-out effect.

Public vs. Gross Debt

Debt held by the public is all federal debt held by states, corporations, individuals, and foreign governments. - Types of securities held by the public include, but are not limited to, Treasury Bills, Notes, Bonds, United States Savings Bonds, and State and Local Government Series securities. Gross debt includes funds owned by the government (Social Security Trust Fund)

Changes in equilibrium income and expenditures

Equilibrium is a point where there is no tendency to move; AE = real GDP. In reality, real GDP does move. If autonomous expenditures increase, then the equilibrium level of real GDP will increase. We use the spending multiplier to calculate this change in real GDP.

Leakages and injections

Equilibrium will occur where leakages and injections intersect (graphically). Leakages and injections increase or reduce autonomous aggregate expenditures.

True or False: In developing countries, direct taxation generally provides a larger share of government revenue than indirect taxation.

False Because indirect taxes— taxes on goods and services—are easier for governments in developing countries to collect than direct taxes—taxes on individuals and firms—indirect taxes generally provide the larger share of government revenue in developing countries.

This table shows some information on a private closed economy. Recall that a private closed economy is one that does not have a government and does not trade with the rest of the world. Therefore, the only components of aggregate expenditure are consumption (C) and planned investment spending (I). In this problem, assume that planned investment spending is independent of the economy's real GDP level. Also note that real GDP is equal to disposable income in a private closed economy. Real GDPConsumption savingsInvestmentAE Unplanned changes 500 455 45 120 _____ -75 600 _____ 70 120 650 _____ 700 605 ___ 120 725 _____ 800 680 120 120 800 _____ _____ 755 145 120 875 25 Real GDP - Savings = Consumption Real GDP - Consumption = Savings AE + Unplanned changes = Real GDP Tendency of Output? (Increase, decrease, equilibrium) True or False: The most fundamental assumption behind the aggregate expenditure model is that prices in the economy are flexible. (True/False) When aggregate expenditure is greater than real GDP, there is an unplanned _________ (increase/decrease) in business inventories. This unplanned change in inventories will cause the actual level of investment to be __________ (less/greater)than the planned level of investment (I), which will prompt firms to ________ (decrease/increase) employment and production.

False decrease/less/increase

Components of fiscal policy

Fiscal policy maintains 2 components: - Discretionary fiscal policy - Changes in govt. spending and taxation aimed at achieving a policy goal (conscious decisions by policymakers). - Automatic stabilizers - Elements of fiscal policy that change automatically as income changes

(S4A)The spending multiplier and the GDP gap

Formula: GDP Gap: potential real GDP - actual real GDP The spending multiplier can also serve as a useful tool if the govt. wants to eliminate the GDP gap. In other words , if potential GDP is higher than actual GDP in the economy, the spending multiplier allows the govt. to forecast how much they need to increase autonomous expenditures in order to eliminate the GDP gap.

AD & Real GDP

How much the government increases/decreases spending influences how far the AD curve will shift. The affect on real GDP is also affected by aggregate supply (more specifically, where the AS curve the AD curve intersect). The results of a change in AD differ in a Keynesian model for real GDP.

How do Aggregate expenditures affect income, or real GDP?

In reality, AE (planned spending) may not equal real GDP (real GDP must rise or fall to reach equilibrium).

The spending multiplier in reality

In reality, the spending multiplier is oversimplified. Often, factors other than MPS and MPI in the economy will affect the multiplier effect. Factors include: Price changes Taxes Both these factors cause the spending multiplier to be overstated Foreign repercussions Cause the spending multiplier to be understated

Supply-Side Economics

In the 1980's (during Reagan's presidency) a new economic theory was introduced, known as Supply Side Economics. Reagan's economists believed that cutting taxes would stimulate the supply of goods and services to the point that tax revenues would actually increase (even though tax rates as a % of income had been cut). - This is illustrated in a Laffer Curve. - Named after economist Arthur Laffer

Macroeconomic Equilibrium Equalilibrium - a point of balance with no tendency to move

Is the level of income and expenditures that the whole economy moves towards (and remains at) until autonomous spending changes.

AE and Aggregate demand

Keynesian model A problem with this model is that it is a fixed-price model (the supply of goods and services will always adjust to AE). In reality, prices as well as production adjust to the differences between supply and demand.

Govt. Spending Financed by Borrowing

Like govt. spending that is financed by taxation, if the govt. borrows to finance higher spending, this can limit the increase in AD. Why do you think this is? Governments borrow through buying bonds that have to be repaid in the future. Current govt. borrowing translates into higher taxes in the future. This can affect: Consumer expectations spending/saving Business expectations spending/saving

Crowding Out

Like the Ricardian Equivalence, crowding out is a debatable theory among economists. Crowding out is related to govt. borrowing. It states that when the govt. increases spending through borrowing, this drives up the interest rate, causing private investment to fall.

(S3C) The spending multiplier calculation

Multiplier = 1/leakages Or Multiplier = 1 / (MPS + MPI) (The leakages are the portion of the change in income that are saved (MPS) and the proportion of the change in income that is spent on imports. (MPI)

Fiscal policy

One tool that the government uses to guide the economy. - Spending and taxation - Induce high employment and stable prices

Political power

Politicians will often respond to different groups of constituents by supporting various government programs regardless of the need for tighter fiscal policy. In this sense, budget deficits are often caused by the political response to citizen's desires/needs.

(P4A) The following graph shows the consumption function (C) for a hypothetical private closed economy and a 45-degree line along which aggregate expenditure equals real GDP (AE=Y). Recall that a private closed economy does not have government and does not trade with the rest of the world (so G=0 and (X-M)=0). In a private closed economy, real GDP is equal to disposable income. At the current real interest rate, the level of investment in this economy is equal to $100 billion at each level of real GDP. Use the blue line (circle symbols) to plot this economy's initial aggregate expenditure line, (C + I). Then, use the black point (X symbol) to indicate this economy's initial equilibrium output. Dashed drop lines will automatically extend to both axes. (Hint: You can see two of the coordinates along the consumption function by moussing over the green triangles on the graph.) Check out the points for Real GDP and consumption (AE = y). Real GDP C + I = AE 450 450 100 = _______ 700 600 100 = _______ At the level of equilibrium output you just indicated, the level of saving is equal to_______ . At an output level of $600 billion, aggregate expenditure will be __________ (equal to, greater than, less than) real GDP and firms will experience ____________ (an unplanned decrease, no change, an unplanned increase) in business inventories. Firms will respond to this situation by: (Decreasing production, Leaving production unchanged, Increasing production) At an output level of $650 billion, aggregate expenditure will be __________ (equal to, greater than, less than) real GDP and firms will experience ____________ (an unplanned decrease, no change, an unplanned increase) in business inventories. Firms will respond to this situation by: (Decreasing production, Leaving production unchanged, Increasing production)

Real GDP C + I = AE 450 450 100 = 550 (450,550) 700 600 100 = 700 (700,700) $100 billion less than/an unplanned increase/decreasing production equal to/no change/Leaving production unchanged

(P4B) Suppose the real interest rate falls and the level of investment in this economy decreases by $50 billion. Use the blue line (circle symbols) to show the economy's aggregate expenditure line, (C + I), after the increase in investment. Then use the gray point (star symbol) to show the economy's new equilibrium output. Dashed drop lines will extend to both axes. 100 - 50 = 50 Hint: Start with your aggregate expenditure line from the previous graph. Make sure the slope of the aggregate expenditure line is the same as the previous aggregate expenditure line you just plotted. You can check the slope of the line by clicking on the line after you plot it. Real GDP C + I = AE 450 450 50 = _______ 700 600 50 = _______ The simple spending multiplier for this private closed economy is____ . (Simple spending multiplier)

Real GDP C + I = AE 450 450 50 = 500 (450,500) 700 600 50 = 650 (700,650) 2.5

(Problem 1A) The following table lists federal expenditures, revenues, and GDP for the U.S. economy during several years. Plot the data for revenues and expenditures as a percentage of GDP on the following graph, rounded to the nearest percent. Use the purple points (diamond symbol) for expenditures and the green points (triangle symbol) for revenues. (x/y) * 100

Revenue 15, 17, 17, 17,19 Expenditures 11, 16, 18, 19, 21

Another Theory: Supply-Side Economics

Supply-side economics is the suggestion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward.

Ricardian Equivalence

The 19th century English economist, David Ricardo, was the 1st economist to suggest that govt. borrowing could function exactly like increased current taxes (reducing current household/business expenditures thus reducing the expansionary effect of increased govt. spending). The Ricardian Equivalence is debatable among economists today.

Equilibrium

The equilibrium level of real GDP is where AE = Real GDP. - This is the point on the graph where 45 degree line (all possible points where AE = real GDP) intersects the AE line (planned spending). Real GDP will increase or fall in order to reach the equilibrium level of expenditures in the economy. Once real GDP reaches equilibrium, it tends to stay there. Occurs at the level of real GDP where: AE (C + I + G + NX = real GDP Leakages = injections Both methods give the same level of equilibrium in the economy.

U.S. Federal Budget Process

The federal budget process is established and influenced as much by ________________ as by economics. (In other words, what tends to prevail over sensible economic fiscal policy).

Keynesian SRAS curve with explanation

The following graph presents an aggregate demand curve and two potential aggregate supply curves. Potential output for this economy occurs at a real GDP of $6 billion. Because Keynesians believe that prices are fixed in the region of the supply curve leading up to potential GDP, their conception of aggregate supply is best represented by the curve labeled ASb. The Keynesian model is known as a "fixed price" model because it rests on the assumption that you can increase aggregate demand without increasing the general price level. The flat region of the aggregate supply curve is, therefore, known as the Keynesian region of the AS curve because the movement of the aggregate demand curve in this region affects only the level of output. In the curve labeled AS, the flat region extends all the way up to potential output, reflecting the Keynesian belief that you can increase aggregate demand to restore potential output without experiencing an increase in the price level. Assuming that the Keynesian model is correct, use the black line labeled New AD1 (X symbols) to draw the new aggregate demand curve that would restore potential output. (Note: The new curve must be drawn parallel to the original aggregate demand curve.) Now, assume that aggregate supply is more accurately represented by the other curve, and use the red line labeled AD2 (cross symbols) to draw the new aggregate demand curve that would restore potential GDP. (Note: The new curve must be drawn parallel to the original aggregate demand curve.) In order to restore potential output, aggregate demand must shift to the point where it intersects aggregate supply at a real GDP of $6 billion. If we assume that the Keynesian model is correct, and the supply curve is given by AS, then the new aggregate demand curve must shift to the right by $3 billion to intersect AS at $6 billion (potential GDP). If, on the other hand, we assume that aggregate supply is more accurately represented by the curve labeled AS, then aggregate demand must shift to the right by $4 billion in order to intersect aggregate supply at a real GDP of $6 billion. The lines, therefore, both have a slope of -10, the first passing through the point corresponding to a real GDP of $6 billion and a price level of 95, and the second passing through the point corresponding to a real GDP of $6 billion and a price level of 105. You can see that if prices are increasing in the region leading up to potential output, the shift in aggregate demand needed to restore potential GDP is greater than if the price level remains constant in this region. Because it is unrealistic that prices will not rise along with expenditures in this region, the Keynesian model underestimates the amount of new spending necessary to restore potential output. If the aggregate demand curve begins to slope upward before output reaches its potential, then any increase in aggregate demand within this region will result in an increase in price. This dampens the effect of aggregate demand on real GDP because, as prices rise, the effect of higher nominal expenditures is weakened by the increase in the price level. When the price level can rise, it requires a greater increase in expenditures to raise real GDP to potential. Because of the unrealistic Keynesian assumption that prices will not rise in response to changes in demand (but rather that producers will only adjust their supply), Keynesians underestimate the amount of new spending necessary to restore potential output. Once the economy reaches potential output, the aggregate supply curve becomes nearly vertical, because beyond that point, further increases in demand cannot affect output and will only increase the price level.

(S4B)Recessionary Gap formula

The formula for the recessionary gap tells us the increase in expenditures necessary to reach potential GDP. Formula: GDP/Spending Multiplier So, if our GDP gap is $200, and our spending multiplier is 2.5, the govt. can eliminate the GDP GAP by increasing spending by: $200/2.5 = $80 (recessionary gap)

Possible Offsets to Fiscal Policy

The magnitude of the multiplier effect is affected by different factors, including: - Price levels - If price levels rise as real GDP rises, the multiplier effect will be smaller than they would be if the price levels had remained constant. Why? - How the govt. pays for its spending - The govt. must finance its spending through: 1) taxing; 2) borrowing; and/or 3) creating money (govt. financing through created money is discussed more in Ch 14)

Suppose the government enacts a "balanced budget" change in fiscal policy by lowering taxes and decreasing government spending. Assume the tax decrease affects both consumption and production spending. The effect of government spending on aggregate demand would be greater if the marginal propensity to consume (MPC) were equal to one. (False)

The primary effect of a decrease in government spending is a leftward shift in aggregate demand due to the decrease in government purchases at every price level. At the same time, however, the government spending decrease is lessened by the spending increase due to higher disposable incomes. The increase in consumer and business spending, however, does not entirely offset the decrease in government spending, because people do not spend 100% of an increase in disposable income. People will spend only a certain percentage (given by the marginal propensity to consume) of the money they are now not paying in taxes, and they will save the rest. Because the decrease in government spending outweighs the increase in private spending, the result is a net decrease in aggregate demand. The tax decrease has an effect on production as well since lower taxes increase the incentive to work (and supply output), because the earner retains a larger portion of earnings. The effect on production is smaller than the effect on consumption, however, and thus causes a rightward shift in the supply curve that does not necessarily fully counteract the effect of the leftward shift of the demand curve on real GDP. If the marginal propensity to consume were equal to one, people would spend every additional dollar they earned. This implies that the increase in consumer spending resulting from the decrease in taxes would exactly counteract the decrease in government spending (since a "balanced budget" change implies that government spending goes down by the amount of the tax). Thus if MPC = 1, the effect of a change in government spending and taxation would be zero.

Suppose the government enacts a "balanced budget" change in fiscal policy by lowering taxes and decreasing government spending. Assume the tax decrease affects both consumption and production spending. The effect of government spending on aggregate demand would be zero if the marginal propensity to consume (MPC) were equal to one. (True)

The primary effect of a decrease in government spending is a leftward shift in aggregate demand due to the decrease in government purchases at every price level. At the same time, however, the government spending decrease is lessened by the spending increase due to higher disposable incomes. The increase in consumer and business spending, however, does not entirely offset the decrease in government spending, because people do not spend 100% of an increase in disposable income. People will spend only a certain percentage (given by the marginal propensity to consume) of the money they are now not paying in taxes, and they will save the rest. Because the decrease in government spending outweighs the increase in private spending, the result is a net decrease in aggregate demand. The tax decrease has an effect on production as well since lower taxes increase the incentive to work (and supply output), because the earner retains a larger portion of earnings. The effect on production is smaller than the effect on consumption, however, and thus causes a rightward shift in the supply curve that does not necessarily fully counteract the effect of the leftward shift of the demand curve on real GDP. If the marginal propensity to consume were equal to one, people would spend every additional dollar they earned. This implies that the increase in consumer spending resulting from the decrease in taxes would exactly counteract the decrease in government spending (since a "balanced budget" change implies that government spending goes down by the amount of the tax). Thus if MPC = 1, the effect of a change in government spending and taxation would be zero.

Suppose the government enacts a "balanced budget" change in fiscal policy by increasing spending and raising taxes. Assume the tax increase affects both consumption and production spending. According to the principle of Ricardian equivalence, the effect of increased government spending on aggregate demand would be smaller if it were financed through borrowing instead of taxation. (False)

The primary effect of an increase in government spending is a rightward shift in aggregate demand due to the increase in government purchases at every price level. At the same time, however, the government spending increase is lessened by the spending decrease due to lower disposable incomes. The decrease in consumer and business spending, however, does not entirely offset the increase in government spending, because people do not cut back on spending by the exact amount of a tax increase. People would have spent only a certain percentage (given by the marginal propensity to consume) of the money they now must pay in taxes, and they would have saved the rest. Because the increase in government spending outweighs the decrease in private spending, the result is a net increase in aggregate demand. The tax increase has an effect on production as well since higher taxes decrease the incentive to work (and supply output), because the earner retains a smaller portion of earnings. The effect on production is smaller than the effect on consumption, however, and thus causes a leftward shift in the supply curve that does not necessarily fully counteract the effect of the rightward shift of the demand curve on real GDP. According to the principle of Ricardian equivalence, the effects of government spending financed by selling bonds are the same as those from increasing taxes. David Ricardo made this assertion based on the belief that the public is aware that the future repayment of bonds will require the government to raise future taxes. In order to save money to pay those future taxes, consumers and businesses cut back on spending today.

Action Time Lag

The time between recognizing an economic problem and implementing a policy to solve it is called the action time lag.

Recognition Time Lags

The time required to gather all the information about the current state of the economy is known as the recognition time lag. It often can take months to identify national economic problems Example: Final annual data on GDP is not usually available until 3-6 months after the year's end.

Effect Time Lag

The time that elapses between the implementation of a policy and the results of that policy is known as the effect time lag. It is easy for an economist to demonstrate on paper what fiscal policy is designed to do, but seeing those effects in the real world takes more time.

Transfer Payments

Transfer payments are payments to one person that is funded by taxing others. - Food stamps - Welfare benefits - Unemployment benefits If income is used to establish eligibility for a transfer payment, then we know it is an automatic stabilizer of fiscal policy. Like progressive taxes, they are designed to offset the effects of lower income on spending in the economy.

True or False: Developing countries generally rely more on the government for investment than do developed countries.

True Because of the larger role that state-owned enterprises play in their economies, developing countries generally rely more on the government for investment than do developed countries.

This table shows some information on a private closed economy. Recall that a private closed economy is one that does not have a government and does not trade with the rest of the world. Therefore, the only components of aggregate expenditure are consumption (C) and planned investment spending (I). In this problem, assume that planned investment spending is independent of the economy's real GDP level. Also note that real GDP is equal to disposable income in a private closed economy. Real GDPConsumption savingsInvestmentAE Unplanned changes 100 100 0 100 _____ -100 200 _____ 50 100 250 _____ 300 200 ___ 100 300 _____ 400 250 150 100 350 _____ _____ 300 200 100 400 100 Real GDP - Savings = Consumption Real GDP - Consumption = Savings AE + Unplanned changes = Real GDP Tendency of Output? (Increase, decrease, equilibrium) True or False: The most fundamental assumption behind the aggregate expenditure model is that prices in the economy are fixed. When aggregate expenditure is less than real GDP, there is an unplanned __________ (increase/decrease) in business inventories. This unplanned change in inventories will cause the actual level of investment to be __________ (less/greater) than the planned level of investment (I), which will prompt firms to __________ (increase/decrease) employment and production.

True increase/greater/decrease

Progressive Income Taxes

What is the difference between regressive, proportional & progressive income taxes? U.S. federal income tax is a progressive tax; as income rises, rate of taxation rises. This form of progressive tax is designed to offset the effects of lower income on spending (consumption) by allowing a greater % of earned income to be spent (consumed).

(S1A) When Aggregate expenditures exceed real GDP, Real GDP rises

When planned spending on goods and services is greater than the current value of output, this causes the production of goods and services to increase (GDP increases). - This means that more goods and services are being purchased than are being produced. How can this happen???? - Goods in the past must be sold (in other words, inventories decrease). - When inventories decrease, manufacturers increase production, raising the real level of GDP. -Thus, when AE exceeds real GDP, real GDP rises.

(S1B) When Aggregate expenditures exceed real GDP, Real GDP rises

When planned spending on goods and services is greater than the current value of output, this causes the production of goods and services to increase (GDP increases). - This means that more goods and services are being purchased than are being produced. How can this happen???? - Goods in the past must be sold (in other words, inventories decrease). - When inventories decrease, manufacturers increase production, raising the real level of GDP. -Thus, when AE exceeds real GDP, real GDP rises.

Injections

Will increase autonomous AE. Injections offset the leakages. 3 injections: - Investment ~ Household saving generates money for investments - Government spending ~ Taxes collected by govt. are spent on goods and services - Exports ~ Exports bring foreign expenditures into the domestic economy

Leakages

Will reduce autonomous AE. Three leakages: - Savings ~ The more households save, the less they spend. This could decrease C, thus causing the equilibrium level of real GDP to fall. - Taxes ~ Transfer income away from households, thus, higher taxes can cause decrease in C, lowering equilibrium level of real GDP. - Imports ~ Spending on imports means less money to spend on domestic goods, thus an increase in imports will decrease X, causing equilibrium real GDP to fall.

The following graph shows the aggregate expenditure line (AE) for an economy with a current equilibrium output of $400 billion and a potential output of $600 billion. The economy is experiencing ____________ . The absolute value of the GDP gap in this economy is _________ . Because the simple spending multiplier for this economy is _____ , closing the GDP gap would require a __________ .

a recessionary gap 600 - 400 = 200 1 / (1 -.75) = 4 200 / 4 = 50 $200 billion 4.00 $50 billion increase in investment spending

Suppose the government of Wunderbar wants to finance a $1 million increase in government spending by raising taxes. In addition to affecting consumption, an increase in taxes __________ the cost of taking time off work, which results in a______________ .

decreases/leftward shift of the SRAS curve

Suppose the government of Nettland wants to finance a $1 million increase in government spending by selling bonds. According to the theory by David Ricardo, the public will _____________ because they'll recognize that the government will have to ____________ in the future to pay back the bonds.

spend less today/raise taxes Economist David Ricardo suggested that households and businesses recognize that government borrowing will eventually have to be paid back, which will result in higher future taxes. Knowing that taxes will be higher in the future, consumers and businesses reduce current expenditures in order to increase future savings. The theory that the effect on private spending will be the same whether the government raises current taxes or issues bonds to finance spending is known as the Ricardian equivalence.