Chapter 16: Fiscal Policy

Definitions and Overview

Fiscal policy refers to the use of government spending and taxation to influence the overall level of economic activity, particularly aggregate demand, output, and employment.

• Fiscal policy tools: The primary tools are changes in government expenditures and changes in tax rates or tax structures.

• Automatic stabilizers: Economic policies and programs that automatically help stabilize an economy by increasing spending or reducing taxes without additional government action (e.g., unemployment insurance, progressive income taxes).

• Discretionary fiscal policy: Deliberate changes in government spending or taxation to influence economic conditions, typically enacted through new legislation.

Effects of Fiscal Policy

• Expansionary fiscal policy: Involves increasing government spending and/or decreasing taxes to boost aggregate demand, typically used during recessions.

• Contractionary fiscal policy: Involves decreasing government spending and/or increasing taxes to reduce aggregate demand, typically used to combat inflation.

• Interpretation using AD/AS models: Fiscal policy shifts the aggregate demand (AD) curve. Expansionary policy shifts AD rightward, increasing output and price level; contractionary policy shifts AD leftward, reducing output and price level.

• Static vs. dynamic AD/AS model: The static model assumes no growth or inflation over time, while the dynamic model incorporates economic growth and expected inflation, providing a more realistic analysis of fiscal policy effects.

Government Budget Deficits and Crowding Out

• Government budget deficit: Occurs when government expenditures exceed tax revenues in a given period.

• Crowding out: When increased government spending leads to higher interest rates, which reduces private investment spending, partially offsetting the impact of fiscal stimulus.

Multipliers in Fiscal Policy

• Government purchases multiplier: Measures the change in aggregate output (GDP) resulting from a change in government purchases.

Formula:

• Tax multiplier: Measures the change in aggregate output resulting from a change in taxes.

Formula:

• Balanced budget multiplier: The combined effect of increasing government spending and taxes by the same amount. Theoretically, the balanced budget multiplier is 1, meaning output increases by the same amount as the increase in government spending, even when taxes rise by the same amount.

Example: If the marginal propensity to consume (MPC) is 0.8, the government purchases multiplier is , and the tax multiplier is .

Coordination of Monetary and Fiscal Policy

• Monetary and fiscal policy can be used together to stabilize the economy. For example, during a recession, expansionary fiscal policy (increased government spending or tax cuts) can be combined with expansionary monetary policy (lower interest rates) to maximize the impact on aggregate demand.

Chapter 17: Inflation and Unemployment

Definitions and Key Relationships

• Inflation: The sustained increase in the general price level of goods and services in an economy over time.

• Unemployment: The condition in which people who are able and willing to work cannot find jobs.

The Phillips Curve

The Phillips curve illustrates the short-run inverse relationship between the rate of inflation and the rate of unemployment.

• Short-run Phillips curve (SRPC): Shows a trade-off between inflation and unemployment; as unemployment falls, inflation tends to rise, and vice versa.

• Long-run Phillips curve (LRPC): Is vertical at the natural rate of unemployment, indicating no long-run trade-off between inflation and unemployment.

Structural Relationships and the Natural Rate of Unemployment

• Natural Rate of Unemployment (NRU): The rate of unemployment arising from all sources except fluctuations in aggregate demand (i.e., frictional and structural unemployment).

• Nonaccelerating inflation rate of unemployment (NAIRU): The unemployment rate at which inflation does not accelerate; essentially the same as the natural rate of unemployment.

Shifts of the Short-Run Phillips Curve

• The SRPC can shift due to changes in expectations of inflation, supply shocks, or changes in structural factors in the labor market.

• Role of expectations: If workers and firms expect higher inflation, the SRPC shifts upward; if they expect lower inflation, it shifts downward.

Solving for Real Wages

• Real wage: The wage rate adjusted for inflation, representing the purchasing power of income from work.

Formula:

Relationship Between Inflation, Unemployment, and Real Wages

• When inflation rises unexpectedly, real wages may fall if nominal wages do not adjust quickly, benefiting employers but reducing workers' purchasing power.

• When unemployment is low, upward pressure on wages and prices can lead to higher inflation.

• When unemployment is high, downward pressure on wages and prices can lead to lower inflation or even deflation.

Example: If the nominal wage is \frac{20}{1.25} = 16$ (in base year dollars).

Summary Table: Phillips Curve Concepts