Fiscal Policy

Which taxes, when reduced, increase LRAS?

1. Personal income tax. 2. Company income tax. 3. Taxes on capital gains.

What are the two shortcomings of fiscal policy.

1. Timing lags (politicians need to gather data, approve legislation). 2. Crowding out.

Between 1970-2015, what has government expenditure fluctuated between?

18-28%.

What is the difference between automatic stabilisers and discretionary fiscal policy?

Automatic stabilisers: government transfers and taxes that AUTOMATICALLY increase or decreases along with the business cycle (e.g. revenue from income taxes naturally increases in booms and decreases in recessions). Discretionary fiscal policy: when the government takes actions to change spending or taxes to achieve economic objectives.

What is the government purchases multiplier?

Change in equilibrium real GDP/change in government purchases.

What is the tax multiplier?

Change in equilibrium real GDP/change in taxes.

Define fiscal policy.

Changes in taxes (T), transfer payments (TR) and government purchases (G).

What are the effects of contractionary fiscal policy?

Decrease in G decreases AD directly, decrease in TR or increase in T will have indirect effect by reducing income and thus AD.

What are different types of fiscal policy?

Expansionary fiscal policy: increases in G, increases in TR, or decreases in T to increase AD. Contractionary fiscal policy: decreases in G, decreases in TR, or increases in T to decrease AD.

When do you use contractionary/expansionary policy?

Expansionary: when economy is below full employment, during an economic contraction or recession. Contractionary: when economy is above full-employment and inflate is high.

Define supply-side policies.

Fiscal policies that have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. They shift LRAS to the right.

How do tax rates influence the multiplier effect?

Higher tax rate = smaller effect. Cut tax = bigger effect.

Should the federal balance always be balanced?

If economy is contracting, or in a recession, there will be a budget deficit. If economy is above potential or during a boom, budget surplus occurs. To maintain a balanced budget might destabilise the economy.

What is resource crowding out?

If government demand bids up the prices of inputs (e.g. wages and steel), these price increases reduce private sector activity.

What is financial crowding out?

If the government borrows money to finance its expenses, there will be an increase in demand for money, increasing the interest rate. This decreases investment.

What are the effects of expansionary fiscal policy?

Increase in G increases AD directly, increase in TR and decreases in T increase AD but only through subsequent increase in C.

Which countries have the highest percentage of budget deficit?

Ireland, Greece.

Is government debt a problem?

It may be necessary during times of economic recession.

What is tax reform and what would the benefits be?

Reform/simplifying tax laws would increase labour force, capital stock and technological change.

What are the effects of contractionary fiscal policy in the short run, long run and very long run?

Short run: price falls and output falls. Long run: prices fall further but output is unchanged (reduces inflation). Very long run: policy is used to combat high inflation, so in the long run when AD increases, it will slow down the rate of increase.

What are the short run, long run and very long run effects of expansionary fiscal policy?

Short run: prices increase, output increases. Long run: prices increase further but output is unchanged (causing inflation). Very long run: LRAS, SRAS and AD curves shift to the right naturally.

What is the equation for a balance budget?

T - G - TR = 0. Where T is taxes, G is government spending, TR is transfer payments.

Define cyclically adjusted surplus or deficit (AKA structural).

The deficit or surplus in the government's budget if the economy were at potential GDP.

Define tax wedge.

The difference between the pre-tax and post-tax return to economic activity.

What happens when T decreases?

The expression on the left hand side will become smaller and increase below 0, causing a budget deficit.

Define crowding out.

The notion that an increase in government purchases causes a decline in private expenditures. In the short run, there is partial crowding out, but in the long run there is full (meaning an increase in government purchases cannot permanently increase GDP).

Define the multiplier effect.

The process by which an autonomous expenditure leads to a larger increase in real GDP (e.g. an increase in government purchases causes AD to shift right (because it is the G component), the multiplier results in a further shift).

What is the difference between fiscal policy and monetary policy?

They both have the same goals of increasing AD, however expansionary monetary policy is is about lowering interest rates, which in turn increase AD. Expansionary fiscal policy increases AD by having the government either increase purchases or cut taxes.

Define budget surplus.

When government expenditures < tax revenue.

Define budget deficit.

When government expenditures > tax revenue.

Can you have a budget surplus if you are in a recession (e.g. not at potential GDP)?

Yes, if the budget line is higher so it intersects the x-axis (real GDP) at an earlier point.