CHAPTER 12 Fiscal Policy

Is government debt GOOD or BAD? 2 benefits

1) Flexible to to unexpected happens EX: Hurricane Katrina 2) Pay for investments that will lead to economic growth and prosperity (higher tax revenues) in the long run EX: Borrow to fund your college education expecting better job in the future

Is government debt GOOD or BAD? 2 costs

1) direct- interest rate 2) indirect- distort the credit market and slow economic growth

Aggregate Demand formula

AD=C+I+G+NX

Contractionary fiscal policy shifts the AD to the left

Decreasing government spending and lowering taxes are fiscal policies with contractionary effects, shifting the aggregate demand curve into the left from AD1 to AD2. This has the effect of decreasing output and price levels.

government spending multiplier formula

GSM= 1/(1-MPC)

Effect expansionary fiscal policy Expansionary fiscal policy restores some AD

If the government decides to pursue expansionary fiscal policy, it will increase spending, which shifts the AD curve rightward. The amount of the shift depends on the amount of spending. her, the governments spending increases output and the price level, but not to their levels before the original fall in AD.

Effect of contractionary fiscal policy Economy overheats from too much AD

In an overheating economy, prices and output are about eh long run equilibrium in the economy

Effect of contractionary fiscal policy Contractionary fiscal policy lowers prices and output

In order to slow down the economy, the government can cut spending or raise taxes, shifting the AD curve leftward.When this happens prices and output fall, although the economy is still above long run equilibrium

Expansionary fiscal policy shifts the AD curve to the right

Increasing government spending and raising taxes are fiscal policies with expansionary effects, shifting the aggregate demand curve out the right from AD1 to Ad2. This has the effect of increasing output and prices levels.

Effect expansionary fiscal policy Initial market response to fall in AD

Initially, with a decrease in aggregate demand the AD curve shifts to the left. At the new equilibrium prices and output are lower than before

taxation multiplier formula

TM=-MPC/(1-MPC)

Contractionary fiscal policy

decisions about taxation and spending intended to decrease aggregate demand

Expansionary Fiscal Policy

decisions about taxation and spending intended to increase aggregate demand

Fiscal Policy

government decisions about the level of taxation and public spending

Higher interest rates

increase the cost of borrowing for businesses that want to invest or consumers who want to buy new homes or cars

When the government borrows money...

it increases the demand for credit and so increases the price of credit-interest rate- in the wider economy.

transfer payments

payments from government accounts to individuals for programs, like social security, that do not involve a purchase of goods or services (Revenue and spending)

automatic stabilizers

taxes and government spending that affect fiscal policy without specific action from policy makers

taxation multiplier

the amount GDP decreases when taxes increases by $1

government spending multiplier

the amount by which GDP increases when government spending increases $1

budget deficit

the amount of money a government spends beyond the revenue it brings in

budget surplus

the amount of revenue a government brings in beyond what it spends

marginal propensity to consume (MPC)

the amount that consumption increases when after tax income increases by $1

multiplier effect

the increase in consumer spending that occurs when spending by one person causes others to spend more too, increasing the impact of the initial spending on the economy

public debt

the total amount of money that a government owes at a point in time