Ch. 11 Fiscal Policy

Chapter 11
Fiscal Policy
Prepared by Murray Davidson, Centennial College.

© 2020 by McGraw-Hill Education Ltd. 1
Learning Objectives
After this chapter you will be able to:
Identify expansionary and contractionary fiscal

policies, which are used by governments seeking
economic stability
Outline the multiplier effect of fiscal policy
Distinguish between budget surpluses and

deficits and their impact on public debt.

Stabilization Policies
Stabilization policy is government policy designed to
lessen the effects of the business cycle.
 It can be either expansionary or contractionary.

 Expansionary policy attempts to reduce
unemployment and stimulate output.

 Contractionary policy attempts to stabilize prices
and reduce too high growth of output.

Stabilizing the Business Cycle
FIGURE 11.1

Stabilization Policies (b)
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.

Expansionary Fiscal Policy
FIGURE 11.2

Contractionary Fiscal Policy
FIGURE 11.3

Automatic Stabilizers
 Automatic stabilizers are built-in measures such as

taxes and transfer payments to lessen the effects of
the business cycle.
 A contracting economy decreases net tax
revenues which increases spending and incomes.
 An expanding economy increases net tax
revenues which decreases spending and incomes.

The Multiplier Effect (a)
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.

The Multiplier Effect (b)
 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 save or withdraw
(MPW), which measures the effect of an income
change on savings/withdrawals (with MPC and
MPW always summing to one).

Impact of Higher Government
Purchases FIGURE 11.4

The Spending Multiplier
 The spending multiplier:
 is 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

The Multiplier Effect and Price
Changes FIGURE 11.5

Changes in Government
Purchases/Taxes
 A change in government purchases causes an initial
spending change of the same amount (and in the
same direction).
 A tax change has a smaller initial impact on

spending (and in the opposite direction).
 The initial spending change is found by
multiplying the tax change by the marginal

propensity to consume (and then reversing the
sign of this change).

Benefits and Drawbacks of 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 three main drawbacks:

 It is subject to delays (recognition lag, decision
lag, impact lag).

 It is politically visible.
 It is closely related to public debt, the amount
owed by the federal government.

The Impact of Fiscal Policy (a)
A government is running a:
 balanced budget when its expenditures and

revenues are equal
 budget surplus when its revenues exceed its

expenditures
 budget deficit when its expenditures exceed its

revenues

The Impact of Fiscal Policy (b)
 Government debt is the sum of all previous budget
deficits.
 When a government has a:
 budget deficit, its total debt increases by the same
amount
 budget surplus, its debt decreases by the same
amount.
 In the past, the federal government tended to run
budget deficits.
 As a consequence, government total debt and debt
payments were on the rise.

Fiscal Policy Guidelines
There are three principles that can guide government
fiscal policy:
 annually balanced budgets
 cyclically balanced budgets
 functional finance

Recent Fiscal Policy in Canada
 There has been a move from functional finance
toward cyclically balanced budgets.
 Total government deficits were highest during the
early 1980s and 1990s.

 The 1980s deficits were largely discretionary
while the 1990s deficits were related to

automatic stabilizers.
 The budget surpluses in the late 1990s and early
2000s were due to automatic stabilizers, lower

interest rates, and government spending cuts.

The Debate Over Public Debt (a)
Supporters of using public debt say:
 public debt provides benefits by reducing the

costs of unemployment
 about 80 percent of federal debt is held by
Canadians, or owed to ourselves

 when debt is used to create productive assets, it
is not necessarily a problem

 there have been times in the past when public
debt as a percent of GDP was higher than now

Public Debt and GDP (billions of
current dollars) FIGURE 11.6

The Debate Over Public Debt (b)
Those against using public debt say:
 public debt charges rise

 provincial and territorial debts need to be taken
into account as well

 there are limits to how much taxes can be raised
to pay public debt charges

 there are potential future burdens associated
with the the amount of Canada’s government

debt held by foreigners

Government Debt Relative to GDP
FIGURE 11.7

Economist Extraordinaire (a)
John Maynard Keynes:
 created a theory to support governments actively

combating the Great Depression
 emphasized the role of aggregate demand in
determining output in the economy

 opposed the neoclassical view that a decline in
wages leads to eliminating unemployment.

A Flexible Labour Market
FIGURE A

An Inflexible Labour Market
FIGURE B

Economist Extraordinaire (b)
 Keynes opposed Say’s Law (which states that supply
creates its own demand).
 He argued that income levels rather than interest

rates adjust to bring a balance between total
injections and total withdrawals.

Public Debt and GDP

Conclusion
Identified expansionary and contractionary fiscal
policies and how they are used by the government
to stabilize economy.
 Explained the multiplier effect of fiscal policy based

on MPC and MPW.
Differentiated between budget surpluses and

deficits and examined their impact on public debt.

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Chapter 11

Prepared by Murray Davidson, Centennial College.

Identify expansionary and contractionary fiscal

Outline the multiplier effect of fiscal policy

Distinguish between budget surpluses and

© 2020 by McGraw-Hill Education Ltd. 2

 It can be either expansionary or contractionary.

unemployment and stimulate output.

and reduce too high growth of output.

© 2020 by McGraw-Hill Education Ltd. 3

© 2020 by McGraw-Hill Education Ltd. 4

 Fiscal policy uses taxes and government purchases.

purchases and/or lower taxes to shift AD rightward.

purchases and/or increased taxes to shift AD leftward.

 Monetary policy uses interest rates and the money

© 2020 by McGraw-Hill Education Ltd. 5

© 2020 by McGraw-Hill Education Ltd. 6

© 2020 by McGraw-Hill Education Ltd. 7

 Automatic stabilizers are built-in measures such as

© 2020 by McGraw-Hill Education Ltd. 8

 An initial spending change produces income and

 This process is repeated with each spending

© 2020 by McGraw-Hill Education Ltd. 9

 Each new spending round is also determined by

© 2020 by McGraw-Hill Education Ltd. 10

© 2020 by McGraw-Hill Education Ltd. 11

 is the value by which an initial spending change is

 The actual change in equilibrium output is less than

© 2020 by McGraw-Hill Education Ltd. 12

© 2020 by McGraw-Hill Education Ltd. 13

 A tax change has a smaller initial impact on

multiplying the tax change by the marginal

© 2020 by McGraw-Hill Education Ltd. 14

 It has a relatively direct impact on spending.

 Fiscal policy has three main drawbacks:

lag, impact lag).

 It is closely related to public debt, the amount

owed by the federal government.

 balanced budget when its expenditures and

 budget surplus when its revenues exceed its

 budget deficit when its expenditures exceed its

© 2020 by McGraw-Hill Education Ltd. 16

 budget deficit, its total debt increases by the same

payments were on the rise.

 annually balanced budgets

 cyclically balanced budgets

© 2020 by McGraw-Hill Education Ltd. 18

early 1980s and 1990s.

while the 1990s deficits were related to

2000s were due to automatic stabilizers, lower

© 2020 by McGraw-Hill Education Ltd. 19

 public debt provides benefits by reducing the

Canadians, or owed to ourselves

is not necessarily a problem

debt as a percent of GDP was higher than now

© 2020 by McGraw-Hill Education Ltd. 20

© 2020 by McGraw-Hill Education Ltd. 21

 public debt charges rise

into account as well

to pay public debt charges