1. Mechanics of Fiscal Policy and its Relation to… AS/AD

2. Fiscal Policy Government efforts to promote full employment and… price stability by changing government spending (G) and/or taxes (T).

3. Countercyclical Fiscal Policy Recession is countered with expansionary policy. Graph AS/AD showing recession. – government spending (G ) – taxes (T ) Inflation is countered with contractionary policy. Graph AS/AD showing inflationary gap. – government spending (G ) – Income taxes (T )   

4. If G or T,then AD shifts causing PL and GDP,which causes u% Expansionary Fiscal Policy       In order to combat recession, the government engages in expansionary policy. Notice that the PL increased: this means expansionary fiscal policy creates some inflation.

5. If G or T,then AD shifts causing PL and GDP, which causes u% Contractionary Fiscal Policy       In order to combat inflation, the government engages in contractionary policy. Notice that the u% increased: this means contractionary fiscal policy creates some unemployment.

6. Expansionary Fiscal Policy GDP R PL AD SRAS LRAS YFYF P Y AD 1 P1P1    IF RECESSION, THEN G↑.: AD .: GDP R ↑ & PL↑.: u%↓ & π% ↑ OR T↓.: DI↑.: C↑.: AD .: GDPR↑ & PL↑.: u%↓ & π% ↑

7. IF INFLATION, THEN G↓.: AD .: GDP R ↓ & PL↓.: u%↑ & π%↓ OR T↑.: DI↓.: C↓.: AD .: GDP R ↓ & PL↓.: u%↑ & π%↓ GDP R PL AD SRAS LRAS YFYF P Y AD 1 P1P1    Contractionary Fiscal Policy

8. Discretionary v. Automatic Fiscal Policies Discretionary – Increasing or Decreasing Government Spending and/or Taxes in order to return the economy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem Automatic – Unemployment compensation & marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Automatic fiscal policy takes place without policy makers having to respond to current economic problems.

9. Weaknesses of Fiscal Policy Lags – Inside lag – it takes time to recognize economic problems and to promote solutions to those problems – Outside lag – it takes time to implement solutions to problems Political Motivation – Politicians face re-election and are more likely to support expansionary rather than contractionary fiscal policy. – Increased government spending and decreased taxes are almost always more popular with voters than increased taxes and decreased spending.

10. Expansionary Fiscal Policy Side-effect: ‘Crowding-out’ of Investment and Net Exports A probable side-effect of increased government spending and reduced taxes is a budget deficit which may lead to the ‘crowding-out’ of Gross Private Investment (I G ) and Net Exports (X N ) loanable funds? Click hereClick here

11. Loanable Funds

12. When G or T, then government must in order to continue spending. This leads to an in the for loanable funds or a decrease in the supply of loanable funds, which results in r %.    borrow increasedemand Effects of Expansionary Fiscal Policy

13. This increase in r % leads to I G. In addition, the increase in r% causes D $ and/or S $ as investors seek higher returns in the U.S. This leads to $ which leads to X and M, so X N.      Effects of Expansionary Fiscal Policy

14. Net Effect of Crowding Out Decreases in IG and XN decrease AD because IG and XN are components of AD. These decreases in IG and XN offset some of the increase in AD brought about by the increase in G.

15. Expansionary Fiscal Policy Side-effect: ‘Crowding-out’ of Investment and Net Exports When G or T, then government must borrow in order to continue spending. This leads to an increase in the demand for loanable funds or a decrease in the supply of loanable funds, which results in r %. This change in r % leads to I G. In addition, the increase in r% causes D $ and/or S $ as investors seek higher returns in the U.S. This leads to $ which leads to X and M, so X N. Because I G and X N are direct components of AD, these decreases offset some of the increase in AD.     Don’t understand loanable funds? Click hereClick here     

16. Expansionary Fiscal Policy Side-effect: ‘Crowding-out’ r% Q LF S LF D LF r q D LF 1 r1r1 q 1 G↑ and/or T↓.: Government deficit spends.: D LF .: r%↑.: I G ↓ (Crowding-Out Effect) r% IGIG IDID II1I1

17. Contractionary Fiscal Policy Side-effect: ‘Crowding-in’ of Investment and Net Exports A probable side-effect of _________government spending and _________taxes is a budget surplus which may lead to the ‘crowding-in’ of Gross Private Investment (I G ) and Net Exports (X N ) When G or T, then government develops a budget _______ This leads to a ___________in the demand for loanable funds or an _________in the supply of loanable funds, which results in r %. This _______in r % leads to I G. In addition, the ________in r% causes D $ and/or S $ as investors seek _______returns abroad. This leads to $ which leads to X and M, so X N. Because ___and ___ are direct components of ___, these increases offset some of the __________in AD.

18. Contractionary Fiscal Policy Side-effect: ‘Crowding-in’ of Investment and Net Exports A possible side-effect of decreased government spending and increased taxes is a budget surplus which may lead to the ‘crowding-in’ of Gross Private Investment (I G ) and Net Exports (X N ) When G or T, then government develops a budget surplus This leads to a decrease in the demand for loanable funds or an increase in the supply of loanable funds, which results in r %. This change in r % leads to I G. In addition, the decrease in r% causes D $ and/or S $ as investors seek higher returns abroad. This leads to $ which leads to X and M, so X N. Because I G and X N are direct components of AD, these increases offset some of the decrease in AD.     loanable funds? Click hereClick here     