Nickling’s Guide to Fiscal Policy DECLASSIFIED

Stabilization Policy  Stabilization policy is a government policy designed to lessen the effects of the business cycle. It can be either contractionary or expansionary.  Expansionary policy attempts to reduce unemployment and stimulate output.  Contractionary policy attempts to stabilize prices and reduce output.

 Stabilization policy can take the form of either fiscal policy or monetary policy.  Fiscal policy uses taxes and government purchases.  Expansionary fiscal policy involves more government purchases and/or lower taxes to shift AD rightward.  Contractionary fiscal policy involves fewer government purchases and/or increased taxes to shift AD leftward.  Monetary policy uses interest rates and the money supply.  Discretionary policy is intentional government intervention in the economy.  Automatic stabilizers are built-in measures such as taxes and transfer payments to lessen the effects of the business cycle.

Benefits and Drawbacks to Fiscal Policy  Fiscal policy has two main benefits:  It can be focused on particular regions.  It has a relatively direct impact on spending.  Fiscal policy has two main drawbacks  It is subject to delays: recognition lag, decision lag, and impact lag.  It is closely related to public debt.

Nickling’s Road to Success in Understanding Fiscal Policies:  In the following cases, would policy-makers raise or reduce government purchases? Why?  Real output is less than potential level. [Raise] because this economy is facing a recessionary gap; AD curve shifts right  Unemployment is below its natural rate. [Reduce] because this economy is facing an inflationary gap, so reduce to stabilize prices; AD curve shifts left  Real output equals its potential level and unemployment is at its natural rate. [Neither] because there’s no inflationary or recessionary gap

 Explain how automatic stabilizers work during the following periods.  The economy is experiencing a recession, with shrinking incomes and spending. Since incomes/spending is decreasing, taxes revenues fall, however government transfers/subsidies is increasing. Therefore, spending will increase as result and apply an expansionary effect on the economy.  The economy is in an expansionary phase, with rising incomes and spending. Since incomes/spending is increasing, taxes revenues rise, however government transfers/subsidies is decreasing. Therefore, spending will decrease as result and apply a contractionary effect on the economy.

The Multiplier Effect  The multiplier effect is the magnified impact of a spending change on AD.  An initial spending change produces income and part of this new income becomes new spending.  This process is repeated with each spending round smaller than the last.  Each new spending round is determined by the marginal propensity to consume (MPC) which measures the effect of an income change on domestic consumption.  Each new spending round is also determined by the marginal propensity to withdraw (MPW) which measures the effect of an income change on withdrawals.  MPC and MPW always summing to one.

The spending multiplier:  The value by which an initial spending change is multiplied to give the total shift in the AD curve.  Equals (1/MPW).  The actual change in equilibrium output is less than the change in AD found using the spending multiplier because of price changes.

Nickling’s Road to Success in Understanding Fiscal Policies: A)If an economy is initially in equilibrium and injections rise by $1 million, then by how much will withdrawals have to rise in order to bring injections and withdrawals back in balance? Withdrawals will have to rise by the same amount of $1 million to bring injections and withdrawals back into balance. B)If the economy’s MPW is 0.67 then by how much will incomes and output have to rise to create the required additional expenditures? Incomes and output must rise by $1.5 million, since each $1.50 in extra income will create $1 [=(0.67 x 1.50)] in additional withdrawals. C)Explain how your answer to part B. is based on the formula for the spending multiplier. The 1.5 million found in part b can be derived by multiplying the initial $1 million increase in injection

 For each of the following cases, calculate the spending multiplier and state the direction and size of the shift in the AD curve.  Government purchases fall by $10 billion in an economy with an MPW of Left, billion  A tax cut causes an initial $25 billion rise in spending in an economy with an MPW of Right, 6.25 billion  Government purchases rise by $15 billion in an economy with an MPC of Right, 20 billion  A $30 billion tax rise occurs in an economy with an MPC of  Left, 22.5 billion