Fiscal Policy Automatic Stabilizers

Thursday March 21, 2013 – Periods 4 & 5

Automatic stabilizers are policy programs whose actions are counter-cyclical and do not require specific action on the part of policymakers. For example, during recessions, government spending automatically increases for unemployment benefits, food stamps, and other programs when more people meet eligibility requirements. During inflation, the progressive tax system charges higher marginal tax rates for those whose incomes are rising faster than the inflation rate. While these automatic stabilizers can help to reduce the effects of economic cycles, discretionary fiscal and monetary policy are much more powerful tools to restore economic stability.

Fiscal Policy Multiplier Effect

Wednesday March 20, 2013 – Periods 4 & 5

Because of the multiplier effect on changes in aggregate demand, the government does not have to fully fill a recessionary or inflationary gap with fiscal policy. The government can use the same multiplier in reverse. For example, if the multiplier is 4 and a $100 billion recessionary gap exists in the economy, government spending must only increase by $25 billion, which will eventually be multiplied by 4 to fully fill the gap.

It is important to note that changes in government spending and taxes have different levels of efficacy. While increases in government spending have a full multiplier effect because they are fully spent in the economy, reductions in taxes are less effective. Because the marginal propensity to consume is less than 1, households will choose to save part of a tax cut and spend the rest. As a result, the multiplier will be lower for a change in taxes than for a change in government spending. Therefore, government would have to change taxes by a greater amount than it would have to change spending, if it wants to achieve the same effect in the economy.

Fiscal Policy Multiplier

Friday March 2, 2012 – Period 7
Wednesday March 7, 2012 – Period 2

  Today we learned that expansionary fiscal policy is defined as an increase in government expenditures, a decrease in taxes, or both increase in government expenditures and decrease in taxes that causes the government’s budget deficit to increase and its budget surplus to decrease. For an economy in a recession, the equilibrium level of real GDP lies below the natural level. This implies that there is less than full employment of the economy’s resources. The way out of this is to run a budget deficit by increasing government expenditures in excess of current tax receipts. The increase in government expenditures should be sufficient to cause the aggregate demand curve to shift to the right restoring the economy to the natural level of real GDP. This increase in government expenditures does not need to be equal to the recessionary gap. Remember that any increase in autonomous aggregate expenditures, including government expenditures, has a multiplier effect on aggregate demand. Therefore, the government needs only to increase its expenditures by a small amount to cause aggregate demand to increase by the amount necessary to achieve the natural level of real GDP.

  Contractionary fiscal policy is defined as a decrease in government expenditures, an increase in taxes, or a decrease in government expenditures and an increase in taxes, which causes the government’s budget deficit to decrease and its budget surplus to increase. Fiscal policy can be used to combat expected increases in the rate of demand-pull inflation. Suppose that the economy is at the natural level of real GDP and that aggregate demand is projected to increase further which will cause the AD curve to shift to the right. As real GDP rises above its natural level, prices also rise, prompting an increase in wages and other resource prices. The end result is inflation of the price level with no change in real GDP. The government can head off this inflation by engaging in a contractionary fiscal policy designed to reduce aggregate demand by enough to prevent the AD curve from shifting. Again, the government needs only to decrease expenditures or increase taxes by a small amount because of the multiplier effects that such actions will have.