A tool that allows the govt to guide the economy along an expansionary or contractionary path EXPANSIONARY (increase in real GDP) CONTRACTIONARY (decrease in real GDP)
What fiscal policy really is
Manipulating govt spending and taxation Manipulating G and T
Recessionary Spending Gap
-What is change in Y, G or X to close the gap? -GAP gap / K = rec. gap -the bigger the multiplier, the better (less money needed to close gap)
Lump sum taxes are...
regressive. (people at lower incomes pay higher %)
t = change in y / change in lump sum taxation t = - (k-1) t = -(MPC-MPI) / (MPS+MPI)
Balance Budget Multiplier
Always equal to 1. Says that like, an increase of G of 100 and decrease of T by 100, then real gdp will increase by 100 (same amount).
Variable. "v" Assume closed economy. Is an extra leakage.
Spending Multiplier (K) with TAX RATES
Kclosed = 1 / (1 - MPC[1-v])
MPC is low and tax rates are high
Spending multiplier is small.
Fiscal policy is most effective when...
prices are fixed. If prices vary, there's no effect on long run GDP.
There is an optimal tax rate, but once you get higher, revenue from taxes goes down (because people stop working)
It's a backwards facing C
How does the government borrow?
Selling bonds to the public. Issue bonds == issue debt Bonds are debt that must be repaid in the long run. Bonds can be paid off with more borrowing, or taxation. So borrowing is a DELAYED tax because it has to be paid back with taxation eventually.
Debt is ...
Debt is a SUBSTITUTE for current taxation
If households and business expect taxes in the future to be higher, they'll reduce spending now to plan for the future. Taxation and government borrowing may both have the same effect on spending in the private sector = ricardian equivalence.
Ricardian --> instead of taxing us today or in the future, the effect is the same on private sector spending
Ricardian Equivalence fail
When people DON'T take into consideration future tax increases. Or when a person is credit constrained. (Ie: the person wants to have a higher level of current spending but is unable to borrow, so savings is negative)
A drop in consumption or investment caused by changes in govt spending. **If an increase in government spending and/or a decrease in tax revenues leads to a deficit that is financed by increased borrowing, then the borrowing can increase interest rates, leading to a reduction in private investment.
Larger the crowding out...
...the less successful the fiscal policy will be.
Discretionary Fiscal Policy
Changes in G and T to achieve a POLICY GOAL (like closing the recessionary gap, or medicare, etc)
Element of fiscal policy that CHANGES automatically as income changes. EX: Tax revenue falls in recessions and rises during booms. Unemployment benefits. This reduces leakages as the economy goes into a recession and increases them as it enters a boom.
Smooth out business cycles.
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