Fiscal Policy

Fiscal Policy→changes in expenditures/tax revenues of federal govt
-2 tools of fiscal policy:

1. taxes→govt can ↑ of ↓ taxes
2. spending→govt can ↑ or ↓ spending

-was enacted to promote our nation's economic goals: FE, price stability, eco. growth

Deficits, Surpluses, + Debt

• Balanced budget→revenues=expenditures
• Budget deficit→revenues<expenditures
• Budget surplus→revenues>expenditures
• Govt debt→sum of all deficits-sum of all surpluses

**In budget deficit, govt must borrow $

-govt borrows from:

• individual 
• corporations
• financial institutions
• foreign entities/foreign govts

Fiscal Policy "Two Options"

1. Discretionary Fiscal Policy (action)

Expansionary FP (think deficit)	Contractionary FP (think surplus)
·         Designed ↑ AD ·         Strategy ↑ GDP, combat recession, and reduce unemployment (PL ↑, creates some inflation) ·         ↑ govt spending (G↑) ·         ↓ taxes (T↓)	·         Designed to ↓AD ·         Strategy for controlling inflation ·         Creates some unemployment ·         ↓ govt spending (G↓) ·         ↑ taxes (T↑)

2. Non-discretionary fiscal p. (no action)

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Discretionary FP	Automatic FP
↑ or ↓ govt spending +/or taxes in order to return economy to FE           Involves policy makers doing FP in response to an economic problem	Unemployment compensation and marginal tax rates are examples that help mitigate (lesses) effects of recession and inflation           Takes place w/out policy makers having to respond to current economic problems

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3 Tax Systems:

Progressive TS	Proportional TS	Regressive TS
Average tax rate (tax revenue/GDP) rises w/ GDP	Average tax rate remains constant as GDP changes	Average tax rate falls w/ GDP

**The more progressive the TS, the greater the economy's built-in stability. 

MPC, MPS, + Multipliers

Spending Multiplier Effect→an initial change in spending (C, Ig, G, Xn) that causes a larger change in aggregate spending, or AD 
-multiplier=△ in AD/△ in spending
-multiplier=△ AD/△ C, I, G, or X
-why does it happen? → expenditures and income flow continuously which sets off a spending ↑ in economy

Calculating the Spending Multiplier
-spending multiplier can be calculated from MPC or MPS
-multiplier=1/(1-MPC) or 1/MPS
-multipliers are (+) when there's an ↑ in spending and (-) when there's a ↓ in spending

Calculating the Tax Multiplier
-when govt taxes, multiplier works in reverse
-Why? Because $ is now leaving the circular flow
-tax multiplier= -MPC/(1-MPC) or -MPC/MPS **note: it's negative
-if there is a TAX-CUT, then multiplier is (+) b/c there is now more $ in circular flow

Consumption Savings

Disposable Income (DI)
-income after taxes/net income
-DI=Gross Income-Taxes

2 Choices:
-w/ DI, households can either

1. consume (spend $ on goods and services)
2. save (not spend)

Consumption

-household spending

-ability to consume is constrained by

• amount of DI
• propensity (tendency) to save

-Do households consume if DI=0? No.

• autonomous consumption
• dissaving

Saving

-household NOT spending

ability to save constrained by

• amount of DI
• propensity to consume

-Do households save if DI=0? No.

APC (average propensity to consume) + APS (average propensity to save)

• APC+APS=1
• 1-APC=APS
• 1-APS=APC
• APC>1: Dissaving
• (-)APS: Dissaver (don't save)

MPC+MPS

-Marginal Propensity to Consume (MPC)

• △C/△DI
• % of every extra dollar earned that's spent

-Marginal Propensity to Save (MPS)

• △S/△DI
• % every dollar earned spent

-MPC+MPS=1

-1-MPC=MPS

-1-MPS=MPC

Determinants of C+S

• wealth 
• expectations
• household debt
• taxes

Graphs of Consumption + Savings:

Investment Demand

Investment→money spent (expenditures) on:

• new plants (factories)
• capital equipment (machinery)
• tech. (hardware and software)
• new homes
• inventories (goods sold by producers) ** Walmart has "just-in-time (best) system

Expected Rates of Return

• How does business make investment decisions? → cost/benefit analysis
• How does business determine the benefits? → expected rate of return
• How does business count the cost? → interest costs
• How does business determine amount of investment they undertake? →compare expected rate of return to interest cost **if expected return>interest rate, invest**if expected return<interest rate, DO NOT invest

Real (r%) v. Nominal (i%)

-Difference: nominal is observable rate of interest. Real subtracts out inflation (π%) aka "ex post facto"

-Compute real interest rate (r%)=i%-π%

-What determines cost of an investment decision? → the real interest rate (r%)

Investment Demand Curve (ID)

-downward sloping curve

-Why?

• when ir (interest rates) are ↑, fewer investments are profitable; when ir are ↓, more investments are profitable
• conversely, few investments yield ↑ rates of return, and many yield ↓ rates of return

Shifts in ID

• cost of production
• business taxes
• technological change
• stock of capital
• expectations

Investment Demand Graph:

Aggregate Supply

Aggregate Supply (AS)→the level of RGDP (GDPr) that firms will produce at each PL

Long-Run v. Short-Run: 

Long-Run (LRAS)	Short-Run (SRAS)
Prd of time where input prices are completely flexible and adjust to changes in PL            Level of RGDP supplied is independent of PL	Prd of time where input prices are sticky and do not adjust to change in PL           Level of RGDP supplied directly related to PL

LRAS→marks level of FE in economy (analogous to PPC) **always vertical at FE

• deals w/ potential output (are we using all resources efficiently?)
• why LRAS shifts: tech., capital resources, growth, entrepreneurship, resources available

SRAS
-△ in SRAS

• increase=shift → (input prices ↓, productivity ↑, +/or deregulation)
• decrease=shift ← (input prices ↑, productivity ↓, +/or deregulation)

-key to understanding shifts in *per unit of production=total input cost/total output

-determinants of SRAS (all of the following affect unit prod. cost)

• input prices (factors of prod., machinery)
• productivity (tech.)
• legal-institutional environment

-increases in resource prices=SRAS ←

-decreases in resource prices=SRAS →

Productivity

-Productivity=total output/total inputs

-more productivity=lower unit of prod. cost=SRAS →

-lower prod.=higher unit of prod. cost=SRAS ←

Ranges/Shapes/Views of AS (Three Schools of Economics)

1. Keynesian Range:

• believe in ↔ curve b/c when economy is below FE, AD shifts outward (↑ in RGDP, unemployment drops, PL is constant) meaning demand creates its own supply
• PL constant=recession
• loss of unemployed resources

2. Intermediate Range:

• AS is b/t Keynesian and Classical Range
• when this occurs, both GDP and PL increases

3. Classical Range:

• in long-run, AS curve is vertical b/c only effects of an ↑ in AD occur at FE, thus, supply creates its own demand (Say's Law)

AS/AD Model: equilibrium of AS and AD determines current output (GDPr) and PL

FE: equilibrium exists where AD intersects SRAS and LRAS at the same point

Recessionary Gap: exists when equilibrium occurs below FE output

Inflationary Gap: exists when equilibrium occurs beyond FE output

AD/AS Shifters

This note sheet composed by Ms. McCartney lists the components that shifts AD and AS.

Unit III: Aggregate Demand

Aggregate Demand (AD)→shows amount of RGDP that private, public, and foreign sectors collectively desire to purchase at each possible price level (relationship b/t PL and level of RGDP is inverse)

Link to AD graph

3 Reasons AD is downward sloping:
   
1. Real-Balance Effect

• when PL is ↑, households and businesses cannot afford to purchase as much output
• when PL is ↓, they can afford to purchase more output

2. Interest-Rate Effect

• a higher PL increases interest rate, which tends to discourage investment
• a lower PL decreases interest rate, which tends to encourage investment

3. Foreign Purchases Effect

• a higher PL increases demand for relatively cheaper imports
• a lower PL increases foreign demand for relatively cheaper U.S. exports

Shifts in AD (2 parts)

1. △ in C, Ig, G, or Xn
2. multiplier effect→produces a greater change than original change in 4 components

Increase in AD=shifts →

Decrease in AD=shifts ←

Govt Spending (e.g. schools, space programs)

• more: AD →
• less: AD ←

Net Exports

-sensitive to:

1. Exchange Rates (international value of $)

• strong $=more imports, fewer exports (AD ←)
• weak $=fewer imports, more exports (AD →) 

2. Relative Income

• strong foreign economies=more exports (AD →)
• weak foreign economies=less exports (AD ←)

3 Types of Aggregate Graphs: