Fiscal Policy Flashcards
(28 cards)
What is fiscal policy?
Fiscal policy refers to the government’s choice regarding levels of spending, taxes, and transfers.
What are the different types of taxes?
1) Income taxes
2) Corporate profit taxes
3) Sales taxes
4) Social insurance taxes (e.g. payroll taxes), and other taxes (e.g. property taxes).
Where does government expenditures come from?
-Obviously the government spends money on interest payments on debt. But aside from that government expenditures come in two forms:
1) Government spending on final goods and services (G)
2) Government transfers (TR) - payments to households for which no good or service is provided in return. Examples include public pension, old age security, childcare benefits, employment insurance and so on.
What are the two ways that fiscal policy can affect aggregate expenditure?
-Fiscal policy affects aggregate expenditure from the national income identity of GDP=C+I+X-IM=AE Planned
-Fiscal policy can affect aggregate expenditure through two ways:
1) Direct effect: Government affects aggregate expendiutre directly by changing government spending on final goods and services (G)
2) Indirect effect: Government affects aggregate expenditure indirectly via changes in taxes and government transfers. Changing transfers and taxes. YD=Y-T+TR is relevant here.
What are the three assumptions to the income expenditure model?
1) Producers are willing to supply additional output at a fixed price. Therefore, a change in aggregate expenditure leads to a change in aggregate output.
2) Interest rate is held fixed
3) Exports and imports are determined autonomously.X=X0 and IM=IM0.
What is the taxes formula?
-T=T0+t*Y
-where T0=autonomous/lump-sum taxes
-t=tax rate and 1>1>0.
-We assume that we will look at the average tax rate Canadians pay.
What is the formula for government transfers?
TR=TR0-tr*Y, where TR0=autonomous/lump-sum transfers.
-tr=transfer benefit reduction rate, 1>tr>0
-As our income rises, we can support ourselves without the help of the government. So the government decreases the transfers given to us to help those in need.
-That’s why tr=transfer benefit reduction rate. If tr=0.05, then for every dollar we get, we receive 5 cents less of transfers.
What is the shortened planned expenditure equation?
AEPlanned=C+IPlanned+G+X-IM.
What are the steps to slving the income expenditure model equilibrium?
Step 1: Express YD as a function of Y
-YD=Y-T+TR
Step 2: Express the consumption funciton as a function of Y.
Step 3: Express the AEPlanned function as a function of Y.
Step 4: Solve for output (Y)&the multiplier(M).
What is the more complex formula for the multiplier in the income expendiiture model?
M=1/1-MPC(1-t-tr)
How do you calculate change in equilibrium output given a change in government expenditure?
Change in Y=Change in Autonomous expenditure*Multiplier
What is automatic stablizing?
-When total output(Y) increases, taxes increase and transfers decrease.
-An increase in total output means that income increases, which increases taxable income, yet also makes it so that the government chooses not to spend transfers.
-Since YD=Y-T+TR, the increase in Y leads disposable income to not increase by that much.
-Automatic stablizers lower the size of the multiplier.
How do you find change in multiplier?
M=Change in Y/Change in Autonomous Expenditure.
What are some counter arguments towards expansionary fiscal policy?
1) Government Spending Crowds Out Private Spending
-Argument: Every dollar that the government spends is a dollar taken away from the private sector. Any increase in government spending will be offset by an equal reduction in private spending.
-Counter argument: This argument is only true if the economy is operating at full-employment, in which output is held fixed(Y=Y-FE).
-If the economy is facing a recessionary gap, expansionary fiscal policy works.
-Recall that YFE=A*F(K,H,L)=C+I+G+NX.
2) Government Borrowing Crowds Out Private Investment Spending?
-Argument: Expansionary fiscal policy lowers public savings, which lowers the supply of loanable funds, which increases the interest rate, and decreases investment. That relates to the crowding out effect.
-Counter argument: The crowding out on investment is less likely to happen when the economy isin a recessionary gap, as an expansionary fiscal policy is likely to increase output and or income. During recession, the supply of loanable funds curve will shift left but only mildly.
3) Government Budget Deficits Lead to Reduced Private Spending
-Argument: Holding all else constant, expansionary fiscal policy may lead to budget deficit. To finance the budget deficit, the government borrows from the public, thus increasing national debt, which will make them raise taxes in the future. Anticipating taxes will raise in the future, consumers spend less(relating to the wealth effect).
-Counterargument: It’s unlikely that households will have such budgeting discipline. Even if they do, they will likely spread that decision over a longer period of time. That means expansionary fiscal policy can still increase output(but by a lesser amount), suggesting it’s still effective.
What is Ricardian equivalence?
-Ricardian equivalence suggests that expansionary fiscal policy has no impact on output.
-To finance the government spending and budget deficit, the government borrows from the public, increasing the stock of national debt.
-To pay off the debt the government must pay taxes.
-Anticipating these taxes, households save more and spend less despite getting more income.
What are the three ways time lags can occur with fiscal policy?
1) It takes time for the government to realize a shock has hit the economy
2) It takes time for the government to develop a plan to respond to the shock. Members of the opposing party often want to argue.
3) It takes time for the change in fiscal policy to have an impact on the economy. Some estimate the time lag for fiscal policy to have an effect is 2 years.
Why can’t we use the government budget balance to assess the fiscal policy stance?
-It would be misleading to observe government budget balance as a proxy for fiscal policy because it is possible for the budget balance to change without a deliberate change in fiscal policy.
-The economy could be in a recession.
What is the formula to assess government budget balance?
GBB=(T0-TR0-G)+(t+tr)*Y
When does the government budget balance change?
1) A deliberate change in fiscal policy like a change in government spending, lump sum tax, and lump sum transfers. It affects the government budget balance directly. But it also affects it indirectly because a change in output will change autonomous expenditure.
2) A change in ouptut that occurs without a deliberate change in fiscal policy. Whenever there is a change in output(Y), government budget balance changes automatically because Y is a part of GBB
What does it mean to assume that part of the budget balance is endogenous? What does this tell us.
-Part of the budget balance is pre-determined in our model.
-This suggests we need to seperate a deficit during a recession from a persistent deficit when the economy is operating at full employment.
-We should be less concerned about budget balance during recessions.
What are the two types of deficit?
1) Structural Deficit: The government runs a budget deficit event when the economy is at full employment.
2) Cyclical Deficit: The GBB equals to 0 when Y=YFE. When output decreases due to recession, then the government budget balance decreases.
When should the government run budget surpluses and deficits?
The government should run surpluses when Y>YFE, and deficits should be ran when Y<YFE, so that the budget is balanced over a period of time.
What are the key formulas that show the relationship between budget balance and national debt?
-National debt(t)=National debt(t-1)-Government budget balance(t)
-Change in National Debt(t)=National debt(t)-National debt(t-1)
What are some of the key problems posed by rising government debt?
1) Persistent budget deficits crowd out investment and lower long-run economic growth.
-Structural deficits lower public savings, decreasing the supply of loanable funds, which raises interest rate, and lowers investment.
-In turn that lowers the investment in physical capital, which lowers physical capital per worker, and lowers our growth rate.
2) Persistent budget deficits lead to the accumulation of national debt.
-When the government borrows from the public to finance its deficits, national debt rises.
-When interest payments creep up, the government has to cut services, increase taxes, or do both.
