National Income and Price Determination: Fiscal Policy

1. National Income and Price Determination: Fiscal Policy AP Economics Mr. Bordelon

2. Stabilization Policy • Stabilization policy. Use of government policy tor educe the severity of recessions and rein in excessively strong expansions. • The free market by itself is self-correcting, however, economists believe that the government can help speed the recovery to full employment and stable prices.

3. Stabilization Policy • Demand Shocks • Positive demand shocks. Cause inflationary gap. APL and real GDP increases. Unemployment decreases, but inflation is a problem. Government policy aims to decrease AD to shorten inflationary gap. • Negative demand shocks. Cause recessionary gap. APL and real GDP decreases. Inflation decreases, but unemployment is a problem. Government policy aims to increase AD to shorten unemployment gap.

4. Stabilization Policy • Supply Shocks. Difficult for government to reverse a supply shock. Therefore they focus on affecting spending (AD) to affect production (AS). • Positive supply shock.Cause inflationary gap. APL decreases and real GDP increases. Unemployment and inflation decrease. Government would avoid action here and let the market self-correct. If government were to act, it would be to decrease AD, which means typically higher taxes and/or decreased government spending to create even lower prices. No politician would do this if they value their political hides. • Negative supply shock. Cause recessionary gap. APL increases and real GDP decreases. Unemployment and inflation increase. Government policy has two options here because the solution is a matter of choice—fight unemployment or fight inflation. • Government policy to shift AD right to fight unemployment. Would increase inflation. End result once LRE achieved, YP achieved, unemployment falls but higher APL. • Government policy to shift AD left to fight inflation. Would increase unemployment. End result once LRE achieved, YP achieved, lower APL, but unemployment higher to achieve it. • In short, somebody gets hurt.

5. Fiscal Policy • Fiscal policy is conducted by the federal government, particularly the President and Congress. Its focus is on taxing, government spending, and government transfers. • Government spending. Part of GDP. Police cars, parks, military. • Transfer payments. Social security, Medicare, food stamps. • Taxation. Sales tax, income tax, property tax. • Borrowing. Government can borrow from banks to make up for shortfalls in tax revenue. This will be covered later, the focus here for fiscal policy will be the first three.

6. Fiscal Policy • How does the government affect AD? • GDP = C + I + G + (X – IM) • G directly affects GDP and thus AD. • Government can indirectly influence C through taxes and transfers. • Shane receives income X from his job. Taxes are paid to the government and sometimes transfer payments are received by the government. What he has left over is YD. YD can be either consumed or saved • YD = Y – taxes + transfers = C + S • C = YD – S • When YD increases, so does C (consumption function!) • Government indirectly increases C by increasing YD by cutting taxes or increasing transfers. • Government can also indirectly decrease C by doing the opposite. • Government can also affect I through taxation.

7. Fiscal Policy • Expansionary fiscal policy. Increases AD. • Contractionary fiscal policy. Decreases AD.

8. Expansionary Fiscal Policy Three actions… Increase in G Decrease taxes Increase govt transfers Expansionary fiscal policy shifts AD right to eliminate recessionary gap.

9. Contractionary Fiscal Policy Three actions… Decrease in G Increase in taxes Decrease in govt transfers Contractionary fiscal policy shifts AD left to eliminate inflationary gap.

10. Problems in Fiscal Policy • Recognition lag. Government has to realize that the recessionary gap exists because economic data takes time to collect and analyze, and recessions are often recognized only months after they have begun. • Decision lag. Government has to develop a spending plan, which can take months, particularly with whiny obstructionist politicians debating how the money should be spent and passing legislation. • Implementation lag. Takes time to spend money. May take a lot of time before impact of big spending is felt. By that time, economy may have already begun to self-correct.

11. Question 1 • The economy is currently experiencing a recessionary gap. List two fiscal policy options that would move the economy closer to potential real GDP. Describe how your policy would achieve the desired result. Use complete sentences.

12. Question 2 • The economy is currently at a level of output that exceeds potential GDP (YP). List two fiscal policy options that would move the economy closer to potential real GDP. Describe how your policy would achieve the desired result. Use complete sentences.