 What can governments do when the there is a downturn or upturn in the economy?  They can stabilize the economy  Example: they can spend more money or reduce taxes to cause changes in total spending and aggregate demand Fiscal Policy

 A Stabilization Policy attempts to influence the amounts spent and produced in an economy  2 Categories:  1. Expansionary Policies: When total output is below its potential, there is unemployment and a recessionary gap  Governments need to reduce unemployment and increase total output  2. Contractionary Policies: When economy is booming, governments want to stabilize prices and bring economy back to its potential output The Goal of Stabilization

 Recall: Governments can affect spending and purchases through taxation and government purchases  Gov’t has an annual budget which sets out what the government will tax and spend  This budget is a stabilization policy  AKA Fiscal Policy (“fiscal” = budgetary)  Fiscal Year: 12-month period to which the budget applies  Monetary Policy: when governments exert their influence on interest rates and the economy’s money supply Stabilizing the Business Cycle

 Effective stabilization policy minimizes the severity of the peaks and troughs in the business cycle  Differences between actual output and the long-run trend of potential output are, therefore, smaller, thus reducing recessionary and inflationary gaps Stabilization Policy and the Business Cycle

 Fiscal policy can be applied to any part of the business cycle  Expansionary Fiscal Policy  Occurs during a recession or depression  Involves increasing government purchases and/or decreasing taxes  Contractionary Fiscal Policy  Occurs during an inflationary period  Policy-makers focus on restraining output and spending  Involves decreasing government spending and/or increasing taxes Use of Fiscal Policy

 A rise in government purchases or a cut in taxes increases aggregate demand, shifting the aggregate demand curve from AD to AD’  This causes a rise in the equilibrium price level, and output rises to its potential level (from left point to right point)  This eliminates economy’s recessionary gap Expansionary Fiscal Policy

 Fiscal Policy involves adjusting government purchases or taxes  Since it’s a government’s choice to pass these laws and create these budgets, fiscal policy is known as discretionary policy  i.e. these are not automatic  Automatic stabilizers in the business cycle include income taxes, employment insurance, welfare and some agricultural subsidies Automatic Stabilizers

 A fall in government purchases or a rise in taxes decreases aggregate demand, shifting the aggregate demand curve to the left from AD 1 to AD 2  This causes a fall in the equilibrium price level, and output falls to its potential level (from right point to left point)  Result: economy’s inflationary gap is eliminated Contractionary Fiscal Policy