Fiscal policy

      Change in Expenditures or tax revenues of the Government.

-       2 Tools of Fiscal Policy: 1) Taxes: Government can increase or decrease taxes

-       2) Spending: Government can increase or decrease spending.

-       The Fed = Federal Reserve

-       Fiscal Policy = Run by the Fed and the President

Deficits, Surpluses, and Debt

Ø  Balanced Budget: Revenues = Expenditures

Ø  Budget Deficit: Budget Revenue < Expenditures

Ø  Budget Surplus: Budget Revenue > Expenditures

Ø  Government Debt: Sum of all Deficits- Sum of all Surpluses

Ø  Government must borrow money when it runs a budget deficit.

o   1) Individuals (taxes)

o   2) Corporations

o   3) Financial Institutions

o   Foreign entities or Governments

Fiscal Policy

Ø  Discretionary Fiscal Policy(action)

o   Expansionary Fiscal Policy – Deficit

o   Contractionary Fiscal Policy – Surplus

Ø  Non-Discretionary Fiscal Policy(No Action)

Discretionary vs. Automatic Fiscal Policy

Discretionary

Increasing or decreasing Government spending and/or taxes to return economy to full employment. This involves policymakers doing Fiscal Policy in Response to an economic problem.

Automatic

Unemployment compensation and Marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Automatic Fiscal Policy takes place without policymakers having to respond to current economic problems.

“Easy”	“Tight”
Expansionary Fiscal Policy	Contractionary Fiscal Policy
*Combat a recession	*Combat Inflation
*Government Spending INCREASES	*Government Spending DECREASES
*Taxes Decrease	Taxes INCREASE

·         Progressive Tax System – Average tax rate (tax revenue / GDP) rises with GDP.

·         Proportional Tax System – Average tax rate remains constant as GDP changes

·         Regressive Tax System – Average tax rate falls with GDP.

Disposable Income(DI)

DISPOSABLE INCOME

Disposable Income is the income after taxes or net income

DI = Gross Income * Taxes

Two Choices

With Disposable Income, households can…

1.    Consume(Spend money on goods and services)

2.    Save (Not Spend money on goods and services)

Consumption

Household Spending- The ability to consume is constrained by:\

1.    The amount of disposable income

2.    The propensity to save

-Households do consume if DI = 0

*Autonomous Consumption

*Dissaving

Saving

Household not spending – The ability to save is hindered by

1.    The amount of Disposable Income

2.    The propensity to Consume

Do Households save if DI = 0 [NO]

APC [Average Propensity to Save] and APS [Average Propensity to Consume]

·          *APC + APS = 1                    *APC > 1(DISSAVING)           *1 – APC = APS

·         *(-APS) = DISSAVING                          * 1 – APS = APC

MPC [Marginal Propensity to Consume] – The fraction of any change in DI that’s consumed.

·         MPC = Change in Consumption / Change in Disposable Income

MPS[ Marginal Propensity to Save] – The fraction of any change in disposable income that is saved.

·         MPS = Change in Savings / Change in Disposable Income

·         Marginal Propensities

·         MPS + MPS = 1

·         MPC = 1 – MPS

·         MPS = 1 – MPC

·         People do 2 things with their Disposable Income, Consume it or Save it!

The Spending Multiplier Effect

-       An initial change in spending [ C , Ig, G, Xn ] causes a larger change in AS or AD

-       Spending Multiplier can be calculated from the MPC or MPS.

-       Multiplier = AD / Change in (C, Ig, G, or Xn)

-       Multiplier = 1 / (1 – MPC)    or 1/ MPS

-       Multipliers are positive (+) when there is an increase in spending and negative (-) when there is a decrease.

-       Tax Multiplier: When Government taxes, the multiplier works in reverse because money is now leaving the circular flow.

-       Tax Multiplier(Note: is Negative)    - Note: if there is a tax cut, then multiplier is positive, because there is now more money in the circular flow.

-       Tax Multiplier = -MPC / (1 – MPC)  or –MPC / MPS

Real nominal (r) vs Nominal (i) Intrest rate

REAL(r) vs. NOMINAL(i) INTEREST RATE

Real Interest Rate : r% = i% - pi%

Determines the cost of an investment decision = The Real Interest Rate

INVESTMENT DEMAND CURVE (ID)

Ø  Downward Sloping

Ø  When interest rates are high, fewer investments are profitable

SHIFTS IN INVESTMENT DEMAND (ID)

Costs of Production                                                         Business Taxes

*Lower costs, IDà                                                              *Lower Business Taxes, ID à

*Higher costs, IDß                                                             Higher Business Taxes, ID ß

Technological Change                                                    Stock of Capital

New Technology, IDà                                                       Economy low on Capital, ID à

Lack of technology, IDß                                                   Economy has alot ofCapital, ID ß

Expectations

Positive, ID à

Negative, ID ß

CLASSICAL

Ø  Classical believes competition is good.

Ø  Believes in invisible hand(Automatic Regulation)

Ø  In the long run, the economy will balance at full employment

Ø  Trickle- Down Effect(Help Rich First, Everybody Else Second)

KEYNESIAN

Ø  AD is Key, Not AS.

Ø  Leaks and Savings cause Recessions.

Ø  In the Long run, we are all dead.

Investment and Investment Demand

In recession prices are fixed, wages are fixed, employment level is flexible
intermediate- prices are flexible, wages fixed, employment level is flexible
inflation- prices are flexible wages, wages are fixed, employment level is fixed
nominal wages- The amount of money received by a worker per unit of time.

Real wages- the amount of goods and services a worker can purchase with their nominal wage

Sticky wages- Nominal wage level that is set according to an initial price level and it does not vary due to labor contracts or other restrictions

Investment

Money spent or expenditure:

• New plants (factories)
• capital equipment (machinery) 
• Technology ( hardware and software)
• New homes
• Inventories (goods sold by producers) 

expected rates of return:

• cost/benefit analysis
• expected rate of return (determining benefits)
• interest cost
• compare expected rate of return to interest cost 

$ expected return < interest to cost (no investment)

$ expected return > interest cost invest

$ This is used when determining the amount of investment an investor should undertake 

Taxes and Subsities

Taxes($ to government) on business increase per unit production cost SRAS ⬅ subsidies from government to business reduce per unit production cost SRAS
Goverment Regulation
Creates a cost compliance = SRAS <
Deregulation reduces compliance cost = SRAS >
Full employment
 equilibrium exist where AD intersects SRAS & LRAS