Unit 3 Aggregate Demand, Supply and Fiscal Policy

Chapter 29 Fiscal Policy

The Car AnalogyThe economy is like a car….1. You can drive 120mph but it is not sustainable.

– (Extremely low unemployment)

2. Driving 20 mph is too slow. The car can easily go faster.– (High unemployment)

3. 70 mph is sustainable. – (Full employment)

4. Some cars have the capacity to drive faster than others.– (Industrial nations vs. 3rd world nations)

5. If the engine (technology) or the gas mileage (productivity) increase then the car can drive at even higher speeds (increase LRAS).

The government’s job is to brake or speed up when needed as well as promote things that will improve the engine.

I. Fiscal Policy

a) Use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve.

Keynes vs. Hayek Video 1

II. Contractionary Fiscal Policy (The BRAKE)

a) Laws that reduce inflation, decrease GDP to close a inflationary gap

1) Decrease Government Spending2) Tax Increases on consumers3) Combinations of the Two

III. Expansionary Fiscal Policy

a) Laws that reduce unemployment and increase GDP or close a recessionary gap.

1) Increase Government Spending2) Decrease Taxes on Consumers3) Combinations of the Two

III. Expansionary Fiscal Policy• What type of gap and what type of policy is best?• What should the government do to spending?• How much should the government spend?

- Why should they not spend $100 billion?

IV. The Multiplier Effect

a) Government Spending 1/(1-MPC)b) Changes in Taxes MPC/(1-MPC)c) Why is the multiplier for government

purchases always going to be larger than the multiplier for a change in taxes?

d) Discretionary Fiscal Policy: deliberate actions from policy makers to influence the economy.

Fiscal Policy Practice

Assume the MPC = .8

1. What type of gap?2. Contractionary or

expansionary needed?3. What are two options to fix

the gap?4. How much initial government

spending is needed to close the gap?

5. $100 Billion

Fiscal Policy Practice

Assume the MPC = .51. What type of gap?2. Contractionary or

expansionary needed?3. What are two options

to fix the gap.4. How much of a change

in government spending is needed to close the gap?

5. -10 Billion

Fiscal Policy Practice

Assume the MPC = .8

1. What type of gap?2. Contractionary or

expansionary needed?3. What are the two options to

fix the gap?4. How much money would the

government have to decrease taxes by to close the gap?

5. $125 Billion

V. Automatic Stabilizers

a) Rules governing taxes and transfers that reduce the size of the multiplier automatically reducing the size of fluctuations in the business cycle.

1) Example: U.S. progressive income tax system acts counter cyclically to stabilize the economy

i. When GDP is down, the tax burden on consumers is low, promoting consumption.

ii. When GDP is up, more tax burden on consumers, discouraging consumption.

iii. The more progressive the tax system, the greater the economy’s built-in stability.

VI. Debt-GDP ratio

a) Widely used measure of fiscal health

Keynes vs. Hayek Round 2

Debate

Statement: Strong government spending and intervention is necessary in times of economic recession and depression.- Strongly Agree- Agree- Disagree- Strongly DisagreeAt the end of this activity you will be required to write a ½ - 1 page paper on your stance.