Chapter Twelve: Module Summary -- Fiscal Policy

  • Fiscal Policy is the attempt by the government to deliberately manipulate its budget position with a goal of stabilizing prices, promoting growth, and minimizing unemployment.

  • A recessionary gap occurs when actual output is less than potential output. An inflationary gap occurs when actual output is greater than potential output.

  • When adding government expenditures to the economy, equilibrium output is determined by the equation Y= C + I + G.

  • The government has three "tools" to conduct fiscal policy: A Change in the level of government expenditures, a change in taxes, and a change in the level of transfer payments.

  • An increase in government expenditures, a decrease in tax rates, or an increase in transfer payments shifts the Aggregate Demand curve to the right, increasing the equilibrium level of output.

  • The tax multipilier is equal to -MPC/(1-MPC).

  • Each of the tools of fiscal policy will bring forth output multiplier effects but the tax multiplier is smaller and has the opposite sign than the simple output multiplier.

  • If the economy is in a recessionary gap, the government will want to stimulate Aggregate Demand via expansionary fiscal policy.

  • If the economy is in an inflationary gap, the government will want to reduce Aggregate Demand via contractionary fiscal policy. This includes a cut in government expenditures, an increase in tax rates, or a decrease in transfer payments.

  • If the AS curve is upward sloping and the government implements expansionary fiscal policy, there is an increase in output and the price level, and output multiplier effects are smaller.

  • Discretionary fiscal policy is policy that must be deliberately enacted by Congress and/or the President. Discretionary fiscal policy suffers from recognition, implementation, and impact lags.

  • Automatic stabilizers are policies that increase spending and decrease taxes automatically during recessions, and decrease spending and increase taxes during growth periods. An example is the income tax. Automatic stabilizers are free from recognition and implementation lags.

  • Supply-side economics is a school of thought that emphasizes the supply side forces of the economy. The goal is to conduct policy that shifts the Aggregate Supply curve to the right.

  • Supply-siders wish to unleash labor resources by lowering marginal tax rates on income. They wish to unleash capital resources by reducing unnecessary business regulations and lowering corporate income and capital gains taxes.

  • Tax cuts lead to deficits, but supply-siders rely on cuts in government spending and the Laffer Curve to prevent massive increases in the deficit.

  • The Laffer Curve plots the tax rate on the horizontal axis and tax revenues collected on the vertical axis. The curve peaks at some point and then begins to decline. The peak is the point on the Laffer Curve that maximizes tax revenue. The key is that higher tax rates reduce the incentive to produce. At some point, then, higher tax rates lead to lower tax revenues. If the economy is too highly taxed, a cut in tax rates may increase tax revenue.

  • The mainstream consensus is that the theory of Supply-side economics is valid, but the empirical effects on labor and capital resources are small.

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