Chapter 14 Sections 1-3, 6-7
During an expansionary economy, public assistance payments and unemployment compensation payments automatically decrease while income taxes automatically increase. What are the effects of these changes on aggregate demand?
-Aggregate demand will be less than it would be without these automatic stabilizers -Aggregate demand will be greater than it was before the expansion.
A contractionary fiscal policy may be implemented in order to:
-Create or expand a budget surplus Contractionary fiscal policy is designed to restrain or cool off the economy during an inflation-inducing business-cycle expansion, this can be accomplished by: a) decreasing government purchases (less expenditures) b) increasing taxes (greater revenues) c) decreasing transfer payments (less expenditures) Thus, starting from a balanced budget situation, a conractionary policy would necessarily create a budget surplus, while if the starting point is a budget surplus, it would expand the already existing budget surplus.
Budget surpluses exist when:
-Government tax revenues exceed its spending. A surplus is an excess of receipts over disbursements. At the government level, receipts are tax revenues and disbursements are government expenditures.
What would lower the unemployment rate?
-Increasing government purchases of goods and services -Decreasing taxes -Increasing transfer payments
Typically, the budget deficit is financed by:
-Issuing debt Therefore, the public debt reflects the net financing accumulated over the years, which is tantamount to say that the public debt would not go dawn as long as there is a budget deficit. For instance, if the fiscal deficit in a given year is $100 billion, that would increase the public debt by $100. "The annual budget deficit is at $720 billion on average for the next 10 years" - Congressional Budget Office (CBO)
What measure is associated with an expansionary fiscal policy?
-Lowering taxes Expansionary fiscal policy is designed to stimulate the economy, by means of increasing aggregate demand, defined as the summation of consumption, investment, government purchases and net exports. This can be accomplished by increasing government expenditures and transfer payments or by lowering taxes. By lowering taxes, disposable income increases, which would lead to increased consumption; thus, causing aggregate demand to rise.
You are a member of Congress when the economy is in a recession. If your goal is to achieve a fully employed labor force, what fiscal policy scenario should you follow?
-Raise government purchases, reduce taxes, and/or increase transfer payments. To achieve the goal of full employment, Congress has to promote a fiscal policy scenario aimed at stimulating aggregate demand either directly through government purchases or indirectly through taxes and transfer payments. Specifically, by means of -Increasing government purchases which directly affects aggregate demand. -Reducing taxes which increases disposable income, which in turn would lead to greater consumption. -Increasing transfer payments which also increases disposable income, which in turn, would lead to greater consumption. Notice that if corporate taxes are reduced, this would lead to increase investments at the firm level and it could also be a part of the policy mix to promote full employment. In all cases, the central idea is to positively impact, directly or indirectly, any of the components of aggregate demand, defined as consumption expenditures + investment expenditures + government purchases + net exports.
If government policy makers were worried about the inflationary potential of the economy, what would be a correct fiscal policy to change?
-decrease the budget deficit -increase consumption taxes -reduce transfer payments THEY WOULD NOT INCREASE THE GOVERNMENT PURCHASES OF GOODS AND SERVICES If government policy makers were worried about the inflationary potential of the economy, they would have to take policy measures aimed at cooling off the economy. Contractionary fiscal policy is designed to cool off the economy by means of reducing aggregate demand, defined as the summation of consumption, investment, government purchases and net exports. Increasing government purchases of goods and services would lead to increased aggregate demand. That would not be contactionary!
Contractionary fiscal policy consists of:
-decreased government purchases, increased taxes, decreased transfer payments Analyze these 3 cases: a) Decreasing government purchases for sure decreases aggregate demand as it is one of its components. b) Increasing taxes reduces disposable income, which in turn, causes consumption to fall and aggregate demand to fall as well. c) Decreasing transfer payments reduces disposable income, which in turn, causes consumption to fall and aggregate demand to fall as well.
Someone earning $150,000 per year will pay the same amount of:
-of Social Security tax as someone earning $150,000,000 per year. The Social Security Tax has a maximum taxable earnings. For year 2015, that amount has been set at $118,500. Therefore, someone making $150,000 or $150,000,000 of taxable earnings pays the same Social Security Tax. Notice that the maximum amount is adjusted every year by the tax authorities. The Social Security Tax provides benefits for retired workers and their dependents as well as for the disabled and their dependents. It is also known as the Federal Insurance Contributions Act (FICA) tax. The Social Security Tax is an example of a regressive tax, since high income earners pay a smaller percentage in taxes.
A decrease in net taxes (taxes minus transfer payments) would do what in the short run?
-reduce unemployment By definition, net taxes equal taxes minus transfer payments. Hence, net taxes decrease if taxes decrease, transfer payments increase, or both. Any of those would imply an expansionary fiscal policy, which is designed to stimulate the economy , by means of increasing aggregate demand. As an end result, unemployment should decline.
If there is initially a federal budget deficit, and taxes fall while transfer payments rise:
AD increases and the budget deficit increases If taxes fall while transfer payments rise (expansionary fiscal policy), then disposable income would increase, and as a result, consumption would rise, and so aggregate demand. Aggregate demand increases whenever any of its components rise. Graphically, the aggregate demand line AD moves rightwards and the economy moves from equilibrium point E to a higher point, ensuing a higher real GDP but also a higher price level. As far as the budget deficit, if taxes fall while transfer payments rise, the deficit clearly widens.
If there is initially a federal budget deficit, and taxes rise, while transfer payments fall:
Aggregate demand decreases and the budget deficit decreases. However, although raising taxes and decreasing transfer payments would decrease the deficit, at least in the short run, these actions are not always good for the economy.
If unemployment is the most significant problem in the economy, what would be an appropriate fiscal policy response?
Decrease taxes and increase government purchases
How do automatic stabilizers work?
During expansions, tax revenues automatically increase (incomes, earnings and profits all rise, so government proceeds). Such increases in tax revenues help weaken economic activity during economic upturns. Conversely, during contractions, tax revenues automatically fall (incomes, earnings and profits all drop, so government proceeds). Such decreases in tax revenues help bolster economic activity during economic downturns. They DO NOT REQUIRE LEGISLATIVE ACTION.
How does a change in income tax primarily affect aggregate demand?
It alters disposable income and consumption spending. Consumption is directly affected by disposable income: the higher(lower) the disposable income, the higher(lower) the consumption level. A tax decrease(increase) implies an increase(decrease) in disposable income.
How does contractionary fiscal policy affect the government's budget?
It decreases the level of aggregate demand either through decreasing government spending or cuts in taxes
What is fiscal policy?
The federal governments efforts to keep the economy table by increasing or decreasing taxes and government spending.
Are budget deficits bad things? How can we tell?
They help stabilize the economy when it goes into recession there is deficit spending through tax cuts or the purchase of goods and services to stop the downward spiral and help to turn the economy.
If the government sought to end a recession, which of the following would be an appropriate policy>
To decrease taxes and increase transfer payments. This would probably both help to end, or at least shorten the recession.
MULTIPLIER EFFECT
a chain reaction of additional income and purchases that results in total purchases that are greater than the initial increase in purchases.
Both an increase in taxes and a decrease in government purchases would have:
a contractionary effect on aggregate demand.
PROGRESSIVE TAX
a tax designed so that those with higher incomes pay a greater proportion of their income in taxes.
FLAT TAX
a tax that charges all income earners the same percentage of their income.
Regressive tax:
a tax where the rate increase as the payer's income decreases
Progressive tax:
a tax where the rate increases as the payer's income increases
REGRESSIVE TAX
as a person's income rises, the amount his or her tax as a proportion of income falls.
AUTOMATIC STABILIZERS
changes in government transfer payments or tax collections that automatically help counter business cycle fluctuations
The main components of spending, which can cause changes in aggregate demand, are:
consumption, investment, government purchases, and net exports. C+I+G+NX
Expansionary fiscal policy, will tend to:
decrease unemployment rates and then businesses will generally want to hire more workers.
VERTICAL EQUITY
different treatment based on level of income and the ability to pay principle.
A business cycle has 4 phases:
expansion, peak, contraction and trough. A contraction or recession is the period between a peak and a trough. During a recession, a significant decline in output and employment spreads across the economy and can last from a few months to more than a year. If output, income and employment declines, necessarily unemployment compensation and welfare payments increase automatically.
When the economy goes into a recession, the amount of taxes collected by the government,
falls automatically. A recession is a phase of the business cycle characterized by a period of declining economic activity. Recessions are generally coupled with higher unemployment, lower incomes, falling profits and rising bankruptcies. As a consequence, income taxes collected by the government, both personal and corporate, fall automatically.
When the economy goes into a recession, the amount of unemployment compensation and welfare payments,
increase automatically
To offset the effect of a steep fall in net exports on the economy, the government might:
increase government purchases. This would help offset the decrease in net exports which would help stimulate the economy.
Decreasing transfer payments would tend to:
increase unemployment
The federal government funds deficit spending by borrowing from the public:
issuing bonds. It could also print money, but this is inflationary and thus seldom used.
What is the benefits received principle?
it bases taxes to pay for public-goods expenditures on a politically-revealed willingness to pay for benefits received.
How does expansionary fiscal policy affect the government's budget?
it increases the level of aggregate demand, either through increasing government spending or decreasing taxes
What is the ability to pay principle?
its a progressive tax that says taxes should be levied according to a taxpayer's ability to pay.
public spending is supported by:
its supported by taxation
BUDGET DEFICIT
occurs when government spending exceeds tax revenues for a given fiscal year.
BUDGET SURPLUS
occurs when tax revenues are greater than government expenditures for a given fiscal year.
The largest single source of revenue for the federal government is the:
personal income tax. Many individuals with low incomes may pay higher amount for Social Security and Medicare tax. The highest taxes paid by unemployed people (and many college students) may be sales taxes.
EXCISE TAX
sales tax on individual products such as alcohol, tobacco, and gasoline.
Why do we have budget deficits?
so when there is a financing gap and the government needs extra money because their spending is larger than tax revenue
The government's fiscal policy is its plan to regulate aggregate demand by manipulating:
taxation and government spending. By altering taxes, take-home income is changed, which impacts consumption, which in turn impacts aggregate demand. By altering government purchases, fiscal policy directly affects aggregate demand, since G is one of its components.
MARGINAL PROPENSITY TO CONSUME [MPC]
the additional consumption resulting from an additional dollar of disposable income.
BENEFITS RECEIVED PRINCIPLE
the belief that those receiving benefits from taxes are those who should pay for them.
ABILITY TO PAY PRINCIPLE
the belief that those with the greatest ability to pay taxes should pay more than those with less ability to pay.
MARGINAL PROPENSITY TO SAVE [MPS]
the change in savings divided by the change in disposable income.
AD will shift to the right, other things being equal, when:
the government budget deficit increases because government purchases rose. If the government increases spending and increases the budget deficit in the process, this is an expansionary fiscal policy, which will shift the aggregate demand curve to the right. In other words, it will stimulate the economy. Fiscal policy aims at affecting aggregate demand, and thus the economy, either directly through government purchases of goods and services, or indirectly through taxes and transfer payments.
EXPANSIONARY FISCAL POLICY
the use of fiscal policy tools to foster increased output by increasing government purchases, lowering taxes, and/or increasing transfer payments.
CONTRACTIONARY FISCAL POLICY
the use of fiscal policy tools to reduce output by decreasing government purchases, increasing taxes, and/or reducing transfer payments.
FISCAL POLICY
the use of government purchases, taxes, and transfer payments to alter equilibrium output and prices.
What are automatic stabilizers?
they are changes in tax collections *income and corporate taxes, for example), or in government transfer payments (unemployment insurance benefits, for example), that automatically help counter business cycle fluctuations. The tax system is the most important automatic stabilizer.
The primary benefit of automatic stabilizers is:
they require no new legislative action, to there is no legislative lag before these tools respond to fluctuations in the business cycle. The two key automative stabilizers are transfer payments and income taxes. When the economy enters into recession, the general level of economic activity declines, unemployment rises, profits fall and incomes drop. As a consequence, transfer payments expand (unemployment compensation and welfare payments increase), while income taxes fall as income drops. Thus, the impact of the recession is somewhat lessened and mitigated by the positive effect of the economic stabilizers, which act automatically, without any specific directive.
What is a flat tax?
where everyone pays the same tax rate regardless of income
If during a recession, total public assistance payments and unemployment compensation payments automatically increase while income taxes automatically decrease, then aggregate demand:
will be more than it would be without these automatic stabilizers
What would be an example or result of expansionary fiscal policy in action?
- A budget deficit. Expansionary fiscal policy is designed to stimulate the economy, This can be accomplished by increasing government expenditures and transfer payments or by reducing taxes. Under either case, the fial purpose is to stimulate aggregate demand. Starting from a situation of equilibrium (balanced budget), an expansionary fiscal policy leads to a budget deficit. (expenditures > revenues). A balanced budget refers to the situation where government revenues equal government expenditures. The CBO (Congressional Budget Office) projects for 2015 a federal budget deficit of $455 billion, or 2.7% of GDP.
If government policy makers were worried about the inflationary potential of the economy, what would be a correct fiscal policy?
- to decrease government purchases of goods and services. this would lead to a lower aggregate demand The government is aiming to cool off the economy so they would use contractionary fiscal policy to reduce aggregate demand, defined as the summation of consumption, investment, government purchases and net exports.
