Fiscal Policy Notes AP Macroeconomics

Fiscal Policy Notes – AP Macroeconomics

A.Defined:

B.Expansionary Fiscal Policy – Used to fight Recession and rising Unemployment:

Options:

1.

2.

3.

The idea here is to the economy and increase AD, employment, and GDP.

C.Contractionary Fiscal Policy to fight Inflation:

Options:

1.

2.

3.

The idea here is to ______the economy and reduce AD without severely affecting employment and GDP.

D.Discretionary Fiscal Policy:

1.Defined: Fiscal policy at the ______of Congress/President.

It requires that a law or governmental regulation be passed.

2.Examples:

a. Making the Automatic Stabilizers more effective.

b. Public Works spending (roads, bridges, dams, etc.)

c. Public Transfer Payments such as unemployment benefits.

d. Changes in Tax Rates (reducing rates during recession or increasing them during inflation).

e. Changes in Government Spending.

E. Automatic or Non-Discretionary Fiscal Policy:

1.Defined: ______

______. All of these provide help to people or a “safety net” under falling AD.

2.Examples

a.Personal Income & Social Security Taxes. Collections of these go down

during recession and up during inflation to help economic stabilization.

b. Personal Savings. Consumers use these funds during recessions.

c. Credit Availability. Used during recessions by consumers.

d. Unemployment Benefits.

e. The Corporate Profits Tax.

f. Other Transfer Payments.

- The more a country’s tax system, the greater an economy’s . ______A progressive tax system increases personal tax rates as people make

more income.

a.Recessions:

During recessions, people make less income, but get a break by paying ______taxes.

b. Inflation:

If people make more money during inflationary periods, theywill pay ______

taxes, thus preventing the economy from overheating.

F. Why are large budget deficits so bad?

1.Absorbs savings & raises interest rates – “the Crowding Out” Effect.

The “Crowding Out Effect” involves the federal government using deficit spending to

increase government spending and get the economy out of arecession. To do this, the

government demands more loanable funds (it sells government securities to the public),

causing the real interest rate toincrease. When the real interest rate increases, investment

demand goes down because it is now more expensive for businesses to borrow money to

invest in plant and equipment. However, if Expansionary Fiscal Policy is effective, the overall stimulative effect should not be offset by the Crowding Out Effect.

2.Increasing dependence on foreign investors to finance the debt, a national sovereignty issue.

3.If the deficits are not paid off, the interest adds to the National Debt.

G. How to Pay off the Debt:

1. Raise Taxes. To collect more revenue for the government. But, no one likes more taxes.

2. Decrease Government Spending. Decreases the need for debt to pay for spending. But,

no one likes their government programs cut.

3. Maintain high economic growth. People like this option . The economic growth would, all

things equal, increase business profits and consumer incomes, providing more tax revenue from

these sources. (This is what Donald Trump is banking on to avoid seriously increasing the

national debt as he plans to reduce taxes and increase spending on infrastructure. Good luck!).

H. What about a balanced budget amendment?

- Problem is it eliminates deficit spending as a stabilization tool.

I. Problems with Fiscal Policy:

1. Inside Lag – Time between the beginning of a recession or inflation and the ______

that it is actually happening and to promote solutions to those problems.

2.Outside Lag –Time it takes to ______solutions to the problems.

3.Political Cycle – Fiscal Policy may be ______for political purposes.

4.Offsets State/Local Finance.

5.Crowding-Out Effect – However, some economists, like John Maynard Keynes, say that during severe recessions or depressions, deficit spending does not crowd-out. This is because interest rates won’t go up as deficit spending would only ______as companieswould not invest during severe economic slack times. In fact, the stimulative effect on AD during this time would “Crowd-In” investment spending.

6. Net Export Effect:

A. Expansionary Fiscal Policy Net Export Effect:

When the federal government usesdeficit spending to increase ______

or______and get the economy out of arecession. To do this, the government

______(it sells government securities to the public), causing the

real interest rate to______. When the ______, foreign

money flows into the U.S. to invest in higher interest rate investments, especially government

securities (bonds). In order topurchase these government securities, foreigners must demand

more U.S. dollars, causing the dollar to ______as shown below:

Afterthe dollar , the followinghappens:

a.U.S. Exports ______as its products become ____ expensive to foreign nations.

b.U.S. Imports ______, however, as Americans have ____ buying power.

c.Therefore, since Net Exports or Xn = Exports minus Imports, Xn goes ______.

d.Finally, as Xn is part of GDPr, then real GDP ______.

However, the stimulative effect of Expansionary policy will only be ______

offsetby the Net Export Effect. This is because Xn comprises only 5% of the U.S.’s

GDPr

B. Contractionary Fiscal Policy Net Export Effect:

When the federal government usesContractionary Fiscal Policy to fight inflation and

______toget the economy out of inflation.

When this happens, the government demands______loanable funds, causing the real

interest rate to______. When the real interest rate ______, foreign money

______flow into the U.S. because interest rates, especially those on

government securities, are lower. As such, the ______for the U.S. dollar would

decrease, causing the dollar to ______as shown below:

Afterthe dollar ______, the following happens:

a. U.S. Exports ______as its products become ______expensive to foreign

nations.

b. U.S. Imports ______, however, as Americans have more ______buying power.

c. Therefore, since Net Exports or Xn = Exports minus Imports, Xn goes ______.

d. Finally, as Xn is part of GDPr, then real GDP ______.

However, the effect Contractionary policy will only be ______offset by

the Net Export Effect. This is because Xn comprises only 5% of the U.S.’s GDPr

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