Fiscal Policy

By: Johnny, Faisal,

Nish, Bianca, &
Kalam
Welcome to Day 1!
Fiscal Policy
The Goal of Stabilization:
• Influence the amount spent and produced in an economy
• Meant to meet potential output
• To have less movements in the business cycle
Use of Fiscal Policy:
• Two Policies : Expansionary Policies and Contractionary
Policies are used to control output
• Injections and withdrawals helps or takes away from the
circular flow
• Governments effects aggregate demand and aggregate supply

• Government purchases have immediate effect on aggregate

demand while tax cuts are less immediate
Automatic Stabilizers:
• Discretionary policies are intentional government intervention in the
economy
• Automatic stabilizers are built-in measures that lessen the effects of
the business cycle
• Examples are taxation and transfer payment programs
Introduction to The Spending
Multiplier:
• The impact policies have on the economy is
like a ripple effect
• Assuming that price is constant, multiplier
effect is the magnified impact of a spending
change on aggregate demand
• Marginal Propensity to Consume answers the
question: “If income increases this amount,
how much extra will be spent on domestic
goods and services?”
•MPC = change in consumption on domestic
items
change in income
Marginal Propensity to Withdraw is the effect
END OF DAY 1!
Have a fabulous day
Day 2: The Spending
Multiplier
The Multiplier Effect

• Government decision-makers estimate the impact of their

policies on the economy by using the multiplier effect
• Multiplier Effect: the magnified impact of a spending
change on aggregate demand

500 250
Spender A ------> Spender B ------> Spender C ------>
Increase in Income: (1000) (500)
(250)
• Marginal Propensity to Consume (MPC): the
effect on domestic consumption of a change in income
• MPC answers the question: “If income increases this
amount, how much extra will be spent on domestic
goods and services?”
MPC= change in consumption on domestic items
------------------------------------------------------
change in income

• Marginal Propensity to Withdraw (MPW): the

effect on withdrawals of a change in income
• 3 types of withdrawals: savings, taxes, and imports
MPW= change in total withdrawals
------------------------------------
change in income
• 1.0 = MPC + MPW
 Multiplier Effect in Detail

1st Round: Government pays Spender A $1000 Real

Output: 1000
(not only income, but also economy’s output)

2nd Round: MPC is 0.5 (500/1000) MPW is also (500/1000)

MPC=$500 MPW=$500 Real Output: 1500

3rd Round: Spender B

MPC=$250 MPW=$250 Real
Output: 1750

Later Spending Rounds:

Total MPC Total MPW Real Output: 2000
for later spending rounds for later spending rounds
=$250 =$250

• Expansion continues until withdrawals equal initial

discretionary injection
• Injections and withdrawals are both $1000 higher than
they were before government purchases were increased
 T he Spending Multiplier
• Spending multiplier is the value by which the
initial spending change is multiplied to give the total
change in output
• Total Change = initial change X spending
in spending in spending multiplier
• recall that the economy’s total output expands
until new withdrawals equal the initial government
purchase
• There is an inverse relationship between MPW and
the spending multiplier ( if MPW is ½, then the
multiplier equals 2) therefore spending multiplier is
the reciprocal of the MPW
• The multiplier effect can also be applied to tax
cuts
• Lower taxes allow others to have more funds to
spend and invest and therefore in this case the
spending multiplier is multiplied with the initial
spending from the tax cut
• Increases the total output and shifts aggregate
demand curve
• Tax adjustment has a small initial effect on
spending
• Since aggregate supply curve gets steeper as it
reaches the potential output level, an increase in
equilibrium makes the price level rise
proportionally more than output
• When economy is above its potential, both price level and total
output falls; price will fall proportionally more than output
•Multiplier effect is useful in indicating the maximum change in
equilibrium output following a certain fiscal policy
 Benefits of Fiscal Policy
• Two benefits as a stabilization tool: its regional
focus, and the direct impact it has on spending
• Regional Focus:
• Parts of Canada may be more affected than others by
the business cycle
• Discretionary fiscal policy can focus on particular
regions where, for example, unemployment rates are
the highest or inflation is at its worst
• Automatic stabilizers have the greatest effect in
regions that need them the most
• Impact on Spending:
• Fiscal policy has a more straightforward impact when
altering government purchases than monetary policy,
since the government itself initiates the change
Drawbacks of Fiscal Policy
• Delays:
• Recognition Lag – the amount of time it takes policy-
makers to realize that a policy is needed
• Decision Lag – the amount of time needed to formulate
and implement an appropriate policy
• Impact Lag – the amount of time between a policy’s
implementation and its having an effect on the economy
• Political Visibility:
• Voters are likely to respond more favourably to increases
in government purchases and cuts in taxes
• Public Debt:
• Public Debt - the total amount owed by the federal
government as a result of its past borrowing
• Public Debt Charges – are the amounts paid out each
year by the federal government to cover the interest
charges on its public debt
End of Day 2
Day 3: Impact of Fiscal
Policy
Impact of Fiscal
Policy
• Balanced budget is the situation where a
government’s expenditure and revenues are equal
• A budget surplus is when a government’s revenues
exceed expenditures
• A budget deficit is when a government’s
expenditure exceeds revenues
• Size of a government’s surplus or deficit in relation to
the economy’s overall GDP gives clues to what type of
discretionary fiscal policy in operation, as well as the
automatic stabilizers
 Budget Surpluses and
Deficits
• Rarely does budget surpluses relate to discretionary fiscal
policy. (Example of such would be the government deciding
to suppress the inflationary effects of an economic boom by
raising income taxes and cutting defense spending
• Budget surpluses are more likely because of built in factors
(rising tax revenues might outweigh transfer payment can
show a surplus during economic booms)
• Budget deficits may indicate active expansionary policies
that increase government expenditures and reduce
revenues
• Budget deficits occur often as a result of automatic
stabilizers (example: les jobs and spending during a
recession leads to rising Unemployment Insurance and
sagging income tax revenues)
 Fiscal Policy Guidelines
• 3 principles that guide government fiscal policy:
1) Annually balanced budgets
2) Cyclically balanced budgets
3) Functional finance
• Annually balanced budget is the principle that
government revenues and expenditures should balanced
each year
• Critics of fiscal policy say annually balanced budget are not
necessary for the society and state it as faulty reasoning
• Cyclically balanced budget is the principle that
government revenues and expenditures should balanced over
the course of one business cycle
Recent Fiscal Policy
• Government revenues and expenditures don’t need to balance
every year but over one business cycle
• Function finance is the principle that government budgets
should be geared to the yearly needs of the economy
• Defenders of functional finance are those who believe fiscal
policy is a powerful stabilization took
• The choice of fiscal policy guideline depends on the
government’s belief in fiscal policy as an effective took for
stabilizing the economy
• 1970s and 1980s Canada believed in functional finance but
recently has made unsuccessful attempts to move toward
cyclically balanced budgets
• Canada’s change of view came from constant budget deficits
and its impact on the economy as a whole
• Government deficits were highest during
recessions during the early 1980s and early 1990s
• Tax revenues fell with slumping incomes during
that time as a result of the automatic stabilizers
• Discretionary expansionary policy also contributed
since federal government increased purchases of
goods and services to counteract the effects of
sagging outputs and incomes
• Canada experienced a period of economic growth,
noticeably during 1988 where unemployment was
under 8%, the economy was at or above potential
output but still budgets didn’t show a surplus
• 1990s downturn caused a concern over increased
public debt and lowered confidence in discretionary
fiscal policies to counteract a recession
End of Day 3