1. Unit 3: Macroeconomics Chapter 9: An Introduction to Macroeconomics Chapter 10: The Business Cycle and Fiscal Policy Chapter 11: Money and Banking

2. Chapter 10: The Business Cycle and Fiscal Policy Overview The macroeconomy and aggregate demand and supply analysis The fluctuations of the economy as explained by the business cycle How the Great Depression led to the development of the Keynesian view of government in economic intervention The use of fiscal policy to influence the business cycle The limitations and drawbacks of using fiscal policy to mange the economy

3. Introduction to Fiscal Policy Chapter 9 introduced critical macroeconomic indicators such as: Unemployment rate Inflation rate (measured as an annual percentage change in the CPI) Economic growth (measured as an annual percentage change in the GDP) In Chapter 1, we examined: How the production possibilities curve helps to describe the choices that an economy faces The potential that exists if all its resources are used to maximum efficiency

4. Introduction to Fiscal Policy In other chapters we also explored how equilibrium is determined in the product, labour, and capital markets These concepts for the foundation necessary to understand how the macroeconomy works and to examine a long-standing economic debate: What is the best way to ensure the economic well- being of our society?

5. Aggregate Demand and Supply In previous chapters, we looked at supply and demand as a way to explain how equilibrium is established in individual markets Our explanation of equilibrium at the macro level begins with a similar analysis

6. Aggregate Demand and Supply In theory, if we could add up all consumer demand, at all various price levels, for all markets, we could determin the total demand schedule for an economy Similarly, if we could add up all of what producers are willing to supply, at all various price levels, for all markets, we could determine the total supply schedule for an economy When we combine all markets for individual goods and services in society, we are looking at the aggregate, or total, for the entire economy

7. Aggregate Demand Aggregate demand (AD) is the total demand for all goods and services produced in a society Table 10.1 shows the total amount of goods and services purchased at each price level, as measured by the chain Fisher volume index, in a particular economy Figure 10.2 is a graph of its aggregate demand curve Looks very similar to the market demand curve studied in Unit 2 As price rises, the total real output (or aggregate quantity demanded) falls

8. Price Level (chain Fisher volume index*) Real GDP Demanded ($ millions) 16077 15082 14087 13091 12096 110101 100105 90110 80115 70119 60124 50129 Table 10.1: Example of total amount of goods and services purchased at each Particular price level in an economy (aggregate demand)

9. Aggregate Demand

10. It should be pointed out that the aggregate demand at each of the price levels is really equivalent to the GDP that would occur at that price level i.e. The sum of all consumption, investment, government spending, and net exports in the economy In the last chapter, we defined this by the formula: GDP = C + I + G + (X – M)

11. Aggregate Demand For real economic growth to occur, the real GDP must grow In other words, the aggregate quantity demanded must increase at each of the price levels This means one or more of the variable in the GDP formula must increase in value

12. Aggregate Supply Aggregate supply (AS) is the total supply of all goods and services produced in a society The aggregate supply curve shows the total amount of goods and services that would be supplied at each price level, as measured by the chain Fisher volume index, in an economy Table 10.3 is an aggregate supply schedule for a particular economy Figure 10.4 is a graph of the aggregate supply curve

13. Price Level (chain Fisher volume index) Real GDP Supplied ($ millions) 160140 150140 139.5 130137.5 120134 100123 90110 8580 8460 8340 Table 10.3: Example of total amount of goods and services supplied at each Particular price level in an economy (aggregate supply)

14. Aggregate Supply

15. While similar in shape to the supply curve from microeconomic supply analysis, the aggregate supply curve does feature important differences The first is the very elastic portion that occurs at low output levels (first part of graph) At very low outputs, most of a society’s resources are sitting idle Ex: When there are many unemployed workers, there is too little competition for workers among producers to force the price of wage labour higher (surpluses force prices down)

16. Aggregate Supply Therefore, there is little increase in the average costs of production when new workers are hired and output is increased Price levels would consequently stay fairly low even as output increases As more output is produced, more competition occurs among producers for limited amounts of land, labour, and capital inputs As these resources become scarcer, their prices go up and put upward pressure on the prices of all goods and services

17. Aggregate Supply At higher output levels, prices tend to rise much more rapidly At some point, the economy would run out of resources altogether Any attempted increase in output would simply result in producers “bidding up” input prices to higher levels without actually producing any more output

18. Aggregate Supply In theory, an economy producing that level of output is producing at a point on its production possibilities curve It can’t physically produce more output without improvements in technology or the discovery of new physical inputs

19. Equilibrium Output and Price Level The point at which the AD curve intersects the AS curve is the equilibrium level of price and output for the economy

21. Equilibrium Output and Price Level When the economy is at full-employment equilibrium the two curves intersect at a point on the AS curve where prices start to rise more rapidly, but the curve is not yet vertical As the economy approached full employment, competition for scarce resources starts to push price levels up The economy still has room for further increases in real GDP because of frictional unemployment and the possibility of increasing output beyond the full- employment level (ex: having employees work overtime)

22. Equilibrium Output and Price Level At some point, the curve would become vertical as an absolute capacity is reached Full-employment equilibrium is the point at which price levels start to rise more quickly, but below the absolute capacity of the economy

23. Equilibrium Output and Price Level Two other possibilities exist for an economy Below full employment equilibrium occurs when the AD curve intersects AS to the left of full- employment equilibrium At this point, real GDP is lower and price levels are rising very lowly The low level of output leads to higher unemployment levels and what is known as a recessionary gap This situation is characterized by high unemployment, low inflation, and low GDP growth

24. Equilibrium Output and Price Level Above full employment, equilibrium occurs when the AD curve intersects AS to the right of full- employment equilibrium At this point, real GDP and employment levels are both very high Price levels, however, are rising very rapidly This is known as an inflationary gap High inflation, high employment levels, and high levels of GDP growth are characteristics of inflationary periods

25. Changes in Aggregate Demand Just as the demand curve might shift in microeconomic analysis, the aggregate demand curve will shift as changes in economic activity are considered Shifts in the aggregate demand curve can be attributed directly to changes in the variables that make up GDP Consumption (C) Investment (I) Government spending (G) The balance of foreign trade (X – M)

26. Changes in Aggregate Demand Changes in consumption Consumer income can be divided into four possible uses Consumption Go to government through taxes Be saved for future use Be spent on imports In terms of impact on aggregate demand (AG) we are most concerned with consumption Makes up 60% of GDP

27. Changes in Aggregate Demand The amount available for consumption is whatever is left over after the other three components are considered As a result, an increase in AD will occur when consumption increases May be the result of either: An increase in the level of income A decrease in one or more of savings, taxes, and import spending An increase in consumption results in a right shift in the AD curve The result is an increase in the equilibirum level of prices, real GDP, and employment A decrease in consumption results in a left shift in the AD curve Decrease in equilibirum level of prices, real GDP, and employment

28. Changes in Aggregate Demand Changes in investment The overall level of investment spending is related to the expectation of future profits If business profits are expected to increase and the economic climate looks strong, investment will increase and the AD curve will shift to the right If businesses foresee a downturn in economic profits, investment will decrease and the AD curve will shift to the left

29. Changes in Aggregate Demand These movements are also closely tied to interest rate Any investment is likely to necessitate the borrowing of funds If the interest rate goes up, the costs associated with the investment also go up This would reduce the potential for profit Increases in interest rates also tend to reduce investment spending, shifting the AD curve to the left Decreases in interest rates have the opposite effect

30. Changes in Aggregate Demand Changes in government spending If a government increases its spending or transfer payments, the AD curve will shift right If a government reduces spending, the AD curve will shift left These changes are at the heart of fiscal policy and will be discussed later in the chapter

31. Changes in Aggregate Demand Changes in export demand (foreign trade) There are three major factors influencing demand for Canadian-produced exports: The domestic rate of inflation The relative levels of income in other countries The value of the Canadian dollar

32. Changes in Aggregate Demand Inflation (or a general increase in the level of prices) affects only domestic and not foreign goods and services A general increase in the price of Canadian goods and services makes them more expensive than foreign-made goods and services A rapid rise in inflation will reduce export demand Foreign consumers will buy fewer Canadian products A decline in the rate of inflation will make Canadian goods less expensive and increase export demand

33. Changes in Aggregate Demand A similar effect will occur as the income levels rise for consumers in countries that are trading partners Their demand for goods will increase and Canadian exports to these countries will rise The opposite will occur for a decrease in the level of foreign incomes

34. Changes in Aggregate Demand Increases in the value of the Canadian dollar will increase the cost of Canadian products for foreign consumers An increase in the value of the Canadian dollar can translate into a decrease in AD because we are selling fewer exports Decreases in the value of the collar make the relative price of Canadian products cheaper for foreign consumers, thus increasing AD

36. Changes in Aggregate Supply Just as events in the marketplace can shift the AD curve, the AS curve is subject to shifts as well There are three reasons why the AS curve might shift: A change in the price of any of the basic inputs (land labour, and capital) A change in the amount of basic inputs available A change in the efficiency of the production process

37. Changes in Aggregate Supply Changes in price of inputs If the prices for land, labour, or capital increase, firms will produce less at each price level The AS curve will shift upward and to the left at all points to the left of its perfectly inelastic section The perfectly inelastic section will not move because, while prices are higher, the same amount of inputs are available Therefore, the maximum real GDP possible is the same as it was before the price increases Decreases in the price of inputs will shift the AS curve downward

38. Changes in Aggregate Supply Changes in the amount of inputs available If new resources are discovered, more capital goods are made available, or the workspace grows, there are more inputs available for use Just as these changes would shift the production possibilities curve outward, they would increase the maximum capacity of the economy The availability of more resources also reduced competition for them, pushing down the costs of basic inputs

39. Changes in Aggregate Supply The effect of the AS curve is: To shift the relatively elastic, horizontal portion downward, reflecting decreases input prices To shift the vertical portion to the right, reflecting the increased capacity of the economy

40. Changes in Aggregate Supply Changes in efficiency Improvements in technology make the workforce more productive As the workforce becomes more efficient, it can produce more output with the same resources The resulting effect on the AS curve is the same as increasing the amount of resources available The curve shits downward, with the vertical portion moving farther to the right

41. Changes in Aggregate Supply

42. The Business Cycle & Aggregate Supply and Demand A business cycle covers periods of alternating economic growth and recession (or negative economic growth) as measured by changes in the real GDP In other words, business cycles are the ups and downs of the economy The duration in time of a business cycle and its size (in loss or gain of real GDP) vary from one cycle to the next

43. The Business Cycle & Aggregate Supply and Demand A business cycle occurs because of the fluctuations that economies experience over time Result from changes in economic growth and patterns of consumption In the previous section, we explained these changes as shifts of the AD and AS curves

44. The Business Cycle & Aggregate Supply and Demand Business cycles are the heart of macroeconomics Economists try to determine how well the economy is doing and where it is heading Forecasting the coming economic climate allows economists to advise political and business leaders on how to deal with possible future economic events When the economy is heading in an undesirable direction, economists can advise a nation’s leaders to apply fiscal or monetary policy tools to try to change the course of the economy

45. The Dynamics of the Business Cycle The causes of these fluctuations in economic activity are varied The cyclical nature of the marketplace is dynamic It’s not possible to detail all the reasons for cyclical fluctuations in the economy We will now go through how a simple macroeconomic model works

47. The Dynamics of the Business Cycle An expansion period begins when consumer spending increases and production increases Represented by an upward trend in the business cycle Let’s assume the Canadian economy is on an upswing Unemployment is declining Business activity is increasing Increased production Increased production leads to new workers being hired New employment leads to a general rise in consumer incomes Generates increased levels of consumption

48. The Dynamics of the Business Cycle Consumer psychology that is influenced by positive economic news can also contribute to increased spending Increased spending translates into an increase in aggregate demand for goods and services This leads to an higher levels of output and employment as well as higher prices This higher demand leads to increased production, more workers being hired, and the cycle starts again This prosperity cycle is the result of aggregate demand feeding itself

49. The Dynamics of the Business Cycle

50. It looks like, as long as resources are available, this trend of greater and greater economic expansion should continue However, at some point the economy will peak, and then the trend will begin to reverse

51. The Dynamics of the Business Cycle The reasons for the turn-around at the peak of a business cycle are varied Consumers may exhaust the purchasing patterns that pushed up aggregate demand Many of the expensive durable goods (ex: cars, appliances, new homes) that drive a booming economy don’t need to be replaced very often Demand begins to decrease when many consumers’ wants are satisfied

52. The Dynamics of the Business Cycle Sometimes the turnaround is linked to an event Ex: the stock market crash of 28 Oct 1929 Combined with restrictive trade policies, the dependence of the resource, and reduced government and investment spending, the result was a huge drop in aggregate demand

53. The Dynamics of the Business Cycle The increase in producers competing for capital funds to support business expansion puts upward pressure on interest rates As interest rates increase, consumers are less likely to buy goods for which they need to borrow money The durable goods that make up 10% of GDP If demand shifts too far to the right, it will exceed the economy’s capacity to produce

54. The Dynamics of the Business Cycle If demand shifts too far to the right, it will exceed the economy’s capacity to produce This will cause more severe inflation As prices rise, higher inflation levels have the effect of reducing the real income of consumers Demand begins to decline

55. The Dynamics of the Business Cycle Together, these factors have the effect of reversing the direction of shift in the aggregate demand curve Instead of moving to the right, as it did while the economy was expanding, it now begins to shift to the left This trend is reflected in the recessionary part of the business cycle, which slopes downward

56. The Dynamics of the Business Cycle The prosperity cycle begins to reverse as we move past the peak of the business cycle Reduced demand for domestic goods leads to firms being overstocked with goods An increase in good surplus indicates to firms that they should cut back production Production cutbacks lead to worker layoffs, which lead to lower incomes Decreased incomes lead to a decrease in consumer demand for goods and services, shifting aggregate demand to the left

57. The Dynamics of the Business Cycle If this occurs, the revenues of firms will tend to decline Some firms will be forced to cut back production in order to control costs, others may lay off workers, and still other firms that can’t reduce their costs may go out of business When this type of downward spiral in economic activity occurs, it is called a recessionary trend

58. The Dynamics of the Business Cycle Officially, a recession occurs when real GDP growth is negative, or declines for two consecutive quarters (three- month periods) The recessionary, or contractionary, part of the business cycle is characterized by: Increasing unemployment Low (or negative) levels of real GDP growth Low levels of inflation or even falling prices (deflation)

59. The Dynamics of the Business Cycle The recessionary period is influenced heavily by consumer psychology Media reports of layoffs (and the threat of more layoffs) cause people who still have jobs to decrease their consumption spending Sometimes people begin to save in order to provide a “cushion” in case they are laid off Others may cut back on the purchase of “big ticket” durable goods, fearing to increase their debt load when wage increases are unlikely and loss of income is possible

60. The Dynamics of the Business Cycle These changes in the level of consumption spending make the recessionary period worse They tend to pull aggregate demand farther to the left If the recessionary period becomes prolonged, with very high unemployment and very low output levels, it is known as a depression

61. The Dynamics of the Business Cycle At some point, events will occur that will stop the downturn in economic activity and will generate increases in consumer spending Prices may fall to a point where consumers start to spend again, and the upward movement of the business cycle resumes Consumers can postpone the purchase of some items only for a certain length of time A new car or fridge is bought when it is no longer worthwhile to repair it Clothes wear out As these purchases occur, inventories of firms begin to dwindle and firms increase production again

62. The Dynamics of the Business Cycle While these regular fluctuations of economic activity occur over varying durations and to varying degrees, over time the level of business activity in an economy tends to increase steadily

63. Leakages and Injections Another explanation of the business cycle centers on the money payments that flow through the economy This circular flow of income sees the GDP as a total of all money payments in the economy Businesses hire individuals from households to work for them and pay them a wage in exchange Businesses also pay individuals money through interest payments on the capital that they borrow for expansion Individuals, in turn, spend the money that they earn on goods and service that the businesses produce This simplified circular flow model can be seen highlighted in green in Figure 10.11

64. Leakages and Injections

65. Leakages are any uses of income that cause money to be taken out of the income-expenditure stream of the economy The income generated by production is subject to three leakages as it is returning to generate more production: Taxes (T) Savings (S) Imports (M) The amount of each of these leakages will rise and fall with the level of production

66. Leakages and Injections “Leaked” money often ends up getting re-spent in the economy The problem is where and how Governments might spend the money they take in taxes But they might also spend more or less than the amount they actually receive in tax revenues Other countries’ export earnings might be used to purchase imports But there is no guarantee that trade will be balanced, or that they will purchase Canadian goods The money we save might be borrowed for business investment inside Canada But then again, it might not

67. Leakages and Injections An injection is any expenditure that causes money to be put into the income-expenditure stream The three major injections into the economy are: Government spending (G) Investment spending (I) Exports (X) Consumption is NOT an injection Consumer incomes are disposed of through consumption, taxes, savings, and import spending If leakages are going up, they reduce consumption spending If leakages are going down, they help increase such spending

68. Leakages and Injections The relationships between the three leakages and three injections determine whether the overall demand is growing or shrinking If leakages > injections = aggregate demand will shrink But as production falls, consumers will pay fewer taxes, save less, and buy fewer imported goods, causing leakages to fall When the leakages falls to the level of the injections, the economy generally stops shrinking The economy is in equilibirum

69. Leakages and Injections The equilibrium may be: Below full employment (a recessionary gap) At full employment Above full employment (a inflationary gap)

70. Leakages and Injections If injections > leakages = aggregate demand will grow But as production and incomes rise, so do taxes, savings and imports, causing leakages to grow When leakages are as large as injections, growth will stop Once again, this may be at, above, or below full- employment equilibrium

71. Leakages and Injections Some have compared this model to filling a bathtub If the amount of water coming in (injection) is greater than the amount going down the drain (leakage), the bathtub fills up (the GDP gets bigger) If the amount of water coming in is less than the amount leaking out, the bathtub empties (the GDP shrinks) If the water coming in and the water leaking out are equal, the amount of water in the tub remains the same (equilibrium)

72. Leakages and Injections This model can be expressed as a formula (see board)

73. Fiscal Policy Most mixed economies go through upheavals caused by the ups and downs of the business cycle Should we as a society do anything about these economic booms and recessions, or should we let the market make its own adjustments?

74. Fiscal Policy John Maynard Keynes believed that the business cycle should be managed Advocated government intervention Governments intervene in the economy through the use of stabilization policies One way that a government can intervene is through applying the tools of fiscal policy

75. Keynes’s Ideas By examining the relationships between demand and income, Keynes was able to explain the Great Depression in a way that classical economists could not A collapse of investment spending brought consumer spending down with it With low levels of consumer spending, it was unlikely investment spending would recover Ex: An auto company that is running at only 50% capacity has no reason to build new factories

76. Keynes’s Ideas But Keynes’s ideas went far beyond simply explaining depressions and recessions If government policy could affect the sizes of leakages (taxes, savings, and imports) and injections (investment spending, government spending, and exports), aggregate demand could be managed

77. Keynes’s Ideas Aggregate demand could be purposely increased in a recession or depression and purposely reduced when excessive demand was leading to inflation This was a revolutionary way of thinking that would influence economic thought for the rest of the 20 th century Ex: the stock market fell in 1987 much more rapidly than it did in 1929, but the rate of economic growth was not greatly affected, partly because governments applied Keynesian theory

78. Keynes’s Ideas Government policies to mange aggregate demand fall into three areas Fiscal policy Monetary policy Trade policy

79. The Basics of Fiscal Policy Fiscal policy is the use by a government of its powers of expenditure, taxation, and borrowing to alter the size of the circular flow of income in the economy so as to bring about: Greater consumer demand More employment Inflationary restraint Other economic goals

80. The Basics of Fiscal Policy If private spending is too small… Government can increase aggregate demand by increasing its own spending or by encouraging private spending If private spending is too large… Government can reduce aggregate demand by decreasing its own spending or by discouraging private spending When the government takes deliberate actions through legislation to alter spending or taxation policies in order to influence the level of spending and employment, it is called discretionary fiscal policy

81. Expansionary Policy When the economy is in a recession: Aggregate demand is low Unemployment is high There is little, or negative, growth in output The government may wish to increase aggregate demand by using an expansionary fiscal policy This would entail a tax cut, an increase in government spending, or both, to stimulate economic growth and lower unemployment rates

82. Expansionary Policy If the government cut taxes, it would increase the disposable income of consumers Assuming the consumers didn’t save this increase or spend it on imports, they would increase the aggregate demand in the economy through consumption The shift in aggregate demand would lead to both an increase in employment and an increase in the growth of GDP as the equilibrium moved closer to full-employment output As long as the equilibrium remained below full-employment equilibrium, there would be little increase in the general level of prices

83. Expansionary Policy The same stimulation of aggregate demand would occur (but for different reasons) if the government used increased government spending as their expansionary policy Government spending is one of the four components of GDP, and therefore, of aggregate demand An increase in government spending would directly shift the aggregate demand curve to the right through the G portion of the GDP equation

84. Expansionary Policy The influence of government spending on aggregate demand is direct A reduction in taxes requires consumers to follow through by spending their increase in income, which they may choose not to do If they choose not to increase consumption, aggregate demand will not increase Because an increase in government spending acts directly on aggregate demand, there is no risk that the policy will not have the desired effect

85. Expansionary Policy If the government wanted to maximize the effect of its expansionary policy, it could use both a tax cut and a spending increase in order to stimulate aggregate demand as much as possible

86. Contractionary Policy When the economy is suffering from inflation: Aggregate demand is too high Employment is high There is high growth in output The government may wish to decrease aggregate demand by using contractionary fiscal policy This would entail a tax increase, a decrease in government spending, or both to reduce upward pressure on prices

87. Contractionary Policy If the government increased taxes… This would effectively decrease the disposable income of consumers In turn, this would decrease the aggregate demand in the economy through the C (consumption) portion of the GDP equation The shift in aggregate demand would lead to a decrease in the inflation rate However, the decrease would also have the trade-off of lowering GDP and employment levels as equilibrium moved back toward full-employment equilibrium

88. Contractionary Policy The government could also address the problem by altering its spending A reduction in government spending would reduce aggregate demand As in expansionary policy, using both would increase the overall effect The overall goal of expansionary and contractionary fiscal policy (known as fiscal stabilization policy) is to smooth out the ups and downs of the business cycle

90. Tools of Fiscal Policy Changes in spending The government can stimulate the economy by increasing general spending in all areas of its programs Health and welfare Culture Education Etc.

91. Tools of Fiscal Policy It can also undertake infrastructure programs Infrastructure is the underlying economic foundation of goods and services that allows a society to operate These programs might include building: Roads Hospitals Schools Communications systems (Ex: laying fiber-optic cable) The added advantage of that they add to the stock of capital goods and Promote the outward shift of the production possibilities curve

92. Tools of Fiscal Policy Changes in taxation To restrain or stimulate economic activity, the government can change the amount of tax it collects This can be accomplished through a number of options: Raise or lower personal and corporate income taxes and/or sales and excise taxes Alter tax exemptions or tax credits Provide special tax incentives for investments, such as larger capital cost allowances on new buildings and equipment This would influence aggregate demand through the I portion of the GDP equation

93. Tools of Fiscal Policy Automatic stabilizers We have looked at discretionary fiscal policies, which require the government to make specific decisions to implements necessary changes to its spending and taxation policies Automatic stabilizers already exist and are acting on aggregate demand before a recession or inflationary trend takes hold Mechanisms built into the economy that automatically increase or decrease aggregate demand when needed Require absolutely no direct actions or legislation by policy markers because they are already legislated

94. Tools of Fiscal Policy Employment insurance and welfare are automatic stabilizers During periods of economic downturn, Employment Insurance payments increase as more people become unemployed Since unemployment increases during recessionary periods, Employment Insurance payments help to maintain incomes and, thus, the consumption portion of GDP If the recessionary period is prolonged, the number of people on welfare rolls also increases The purpose of welfare is to ensure people a level of income so that they can survive But these payments also help to increase consumption This either slows the leftward shift of the AD curve or begin to increase AD

95. Tools of Fiscal Policy Another common type of automatic stabilizer is tax rates that vary with levels of income A progressive tax acts as a stabilizer in that: It rises as incomes rise It has the effect of increasing a leakage as incomes grow At lower levels of income, the tax rate may be 20% But as a person’s income rises, it may start to be taxed at 30% These increases in tax slow down the increase in consumption Stop the aggregate demand curve from shifting too quickly to the right, which could lead to inflation

96. Tools of Fiscal Policy It is important to note that these is also a discretionary element to automatic stabilizers At any time, the government may make a decision to change the level of spending or taxation When these changes are made, they are considered discretionary fiscal measures

97. Government Budget Options Governments in Canada usually announce their changes in revenue and spending plans in the spring by outlining the coming year’s budget In establishing their budget, the government can end up in one of three situations:

98. Government Budget Options Deficit budget Occurs when the government spends more than it collects in tax revenue It must borrow they money to cover the shortfall Surplus budget Occurs when the government collects more in tax revenue than it spends Consequently, it has money left over Balanced budget Results when the government spends an amount equal to what it has collected in tax revenue

99. Government Budget Options The debt is the total amount that a government owes on money it has borrowed to fund deficit budgets Ex: A government spends $150 billion in year 1 but takes in only $130 billion in revenues It has a shortfall, or budget deficit, of $20 billion It must borrow $20 billion In year 2, the government spends $150 billion (including interest on the debt from Year 1) and takes in $140 billion in revenues It has a deficit of $10 billion and an accumulated debt of $30 billion ($20 billion from year 1 and $10 billion from year 2)

100. Drawbacks and Limitations of Fiscal Policy The time lags that exist in utilizing fiscal policy are significant Recognition lag = The time the government takes to recognize a problem in the economy Decision lag = The time required for the government to determine the most appropriate policy Implementation lag = Once the decision has been made, various government departments have to figure out just how to implement the new directives regarding spending and taxation Impact lag = Once the policy is in place, time is required before its full effects can be felt through the multiplier effect

101. Drawbacks and Limitations of Fiscal Policy The government might have difficulty changing spending and taxation policies Raising taxes is often unpopular Cutting spending may be impossible if there are long- term contracts or the programs are very popular with citizens The timing of government elections may also influence spending and taxation policies

102. Drawbacks and Limitations of Fiscal Policy Conflict between the various levels of government regarding the appropriate fiscal policy might limit effectiveness If the federal government is reducing spending and increasing taxes in an effort to slow down economic growth and a powerful provincial government is increasing spending and cutting taxes in order to gain political support, the two policies may offset each other

103. Drawbacks and Limitations of Fiscal Policy Regional variations may exist that interfere with the implementation of fiscal policy If part of the country is doing well while another region is suffering from a slowdown, what policy should be used? An expansionary policy would likely cause inflation in the region doing well, yet a contradictory policy would make the recession worse in the part of the country suffering a slowdown

104. Drawbacks and Limitations of Fiscal Policy The size of the debt can also limit the use of fiscal policy as an effective tool In recent years, the federal debt in Canada has grown so large that there is much political pressure not to increase it further If expansionary policy were desired, the government would have little room to increase spending and cut taxes without increasing the debt The federal government and most provincial governments made deficit reduction the primary focus of fiscal policy during the late 1990s

105. Drawbacks and Limitations of Fiscal Policy Some economists believe that a crowding out of private investment occurs when the government competes with the private sector to borrow funds to finance the debt Argue that this policy drives up interest rates and reduces the amount available for private investment As a result, investment in capital goods decreases and the rate of economic growth slows