Unit 3: Macroeconomics

Unit 3: Macroeconomics

Chapter 9: An Introduction to MacroeconomicsChapter 10: The Business Cycle and Fiscal Policy

Chapter 11: Money and Banking

Chapter 10: The Business Cycle and Fiscal Policy

• Overview• The macroeconomy and aggregate demand and

supply analysis• The fluctuations of the economy as explained by the

business cycle• How the Great Depression led to the development of

the Keynesian view of government in economic intervention

• The use of fiscal policy to influence the business cycle• The limitations and drawbacks of using fiscal policy to

mange the economy

Introduction to Fiscal Policy

• Chapter 9 introduced critical macroeconomic indicators such as:• Unemployment rate• Inflation rate (measured as an annual percentage change

in the CPI)• Economic growth (measured as an annual percentage

change in the GDP)

• In Chapter 1, we examined:• How the production possibilities curve helps to describe

the choices that an economy faces• The potential that exists if all its resources are used to

maximum efficiency

Introduction to Fiscal Policy

• In other chapters we also explored how equilibrium is determined in the product, labour, and capital markets

• These concepts for the foundation necessary to understand how the macroeconomy works and to examine a long-standing economic debate:

• What is the best way to ensure the economic well-being of our society?

Aggregate Demand and Supply

• In previous chapters, we looked at supply and demand as a way to explain how equilibrium is established in individual markets

• Our explanation of equilibrium at the macro level begins with a similar analysis

Aggregate Demand and Supply

• In theory, if we could add up all consumer demand, at all various price levels, for all markets, we could determin the total demand schedule for an economy

• Similarly, if we could add up all of what producers are willing to supply, at all various price levels, for all markets, we could determine the total supply schedule for an economy

• When we combine all markets for individual goods and services in society, we are looking at the aggregate, or total, for the entire economy

Aggregate Demand• Aggregate demand (AD) is the total demand for all

goods and services produced in a society• Table 10.1 shows the total amount of goods and

services purchased at each price level, as measured by the chain Fisher volume index, in a particular economy

• Figure 10.2 is a graph of its aggregate demand curve• Looks very similar to the market demand curve studied

in Unit 2• As price rises, the total real output (or aggregate

quantity demanded) falls

Price Level (chain Fisher volume index*)

Real GDP Demanded ($ millions)

160 77150 82140 87130 91120 96110 101100 10590 11080 11570 11960 12450 129

Table 10.1: Example of total amount of goods and services purchased at eachParticular price level in an economy (aggregate demand)

Aggregate Demand

Aggregate Demand

• It should be pointed out that the aggregate demand at each of the price levels is really equivalent to the GDP that would occur at that price level• i.e. The sum of all consumption, investment,

government spending, and net exports in the economy

• In the last chapter, we defined this by the formula:

GDP = C + I + G + (X – M)

Aggregate Demand

• For real economic growth to occur, the real GDP must grow• In other words, the aggregate quantity

demanded must increase at each of the price levels

• This means one or more of the variable in the GDP formula must increase in value

Aggregate Supply• Aggregate supply (AS) is the total supply of all

goods and services produced in a society• The aggregate supply curve shows the total

amount of goods and services that would be supplied at each price level, as measured by the chain Fisher volume index, in an economy

• Table 10.3 is an aggregate supply schedule for a particular economy

• Figure 10.4 is a graph of the aggregate supply curve

Price Level (chain Fisher volume index)

Real GDP Supplied ($ millions)

160 140150 140140 139.5130 137.5120 134100 12390 11085 8084 6083 40

Table 10.3: Example of total amount of goods and services supplied at eachParticular price level in an economy (aggregate supply)

Aggregate Supply

Aggregate Supply• While similar in shape to the supply curve from

microeconomic supply analysis, the aggregate supply curve does feature important differences

• The first is the very elastic portion that occurs at low output levels (first part of graph)• At very low outputs, most of a society’s resources

are sitting idle• Ex: When there are many unemployed workers,

there is too little competition for workers among producers to force the price of wage labour higher (surpluses force prices down)

Aggregate Supply• Therefore, there is little increase in the average costs of

production when new workers are hired and output is increased

• Price levels would consequently stay fairly low even as output increases

• As more output is produced, more competition occurs among producers for limited amounts of land, labour, and capital inputs

• As these resources become scarcer, their prices go up and put upward pressure on the prices of all goods and services

Aggregate Supply

• At higher output levels, prices tend to rise much more rapidly

• At some point, the economy would run out of resources altogether• Any attempted increase in output would

simply result in producers “bidding up” input prices to higher levels without actually producing any more output

Aggregate Supply

• In theory, an economy producing that level of output is producing at a point on its production possibilities curve• It can’t physically

produce more output without improvements in technology or the discovery of new physical inputs

Equilibrium Output and Price Level

• The point at which the AD curve intersects the AS curve is the equilibrium level of price and output for the economy


• When the economy is at full-employment equilibrium the two curves intersect at a point on the AS curve where prices start to rise more rapidly, but the curve is not yet vertical

• As the economy approached full employment, competition for scarce resources starts to push price levels up

• The economy still has room for further increases in real GDP because of frictional unemployment and the possibility of increasing output beyond the full-employment level (ex: having employees work overtime)


• At some point, the curve would become vertical as an absolute capacity is reached

• Full-employment equilibrium is the point at which price levels start to rise more quickly, but below the absolute capacity of the economy


• Two other possibilities exist for an economy• Below full employment equilibrium occurs when

the AD curve intersects AS to the left of full-employment equilibrium• At this point, real GDP is lower and price levels are

rising very lowly• The low level of output leads to higher

unemployment levels and what is known as a recessionary gap

• This situation is characterized by high unemployment, low inflation, and low GDP growth


• Above full employment, equilibrium occurs when the AD curve intersects AS to the right of full-employment equilibrium• At this point, real GDP and employment levels

are both very high• Price levels, however, are rising very rapidly• This is known as an inflationary gap• High inflation, high employment levels, and

high levels of GDP growth are characteristics of inflationary periods

Changes in Aggregate Demand

• Just as the demand curve might shift in microeconomic analysis, the aggregate demand curve will shift as changes in economic activity are considered

• Shifts in the aggregate demand curve can be attributed directly to changes in the variables that make up GDP• Consumption (C)• Investment (I)• Government spending (G)• The balance of foreign trade (X – M)


Changes in consumption• Consumer income can be divided into four possible

uses• Consumption• Go to government through taxes• Be saved for future use• Be spent on imports

• In terms of impact on aggregate demand (AG) we are most concerned with consumption• Makes up 60% of GDP


• The amount available for consumption is whatever is left over after the other three components are considered• As a result, an increase in AD will occur when consumption increases

• May be the result of either:• An increase in the level of income• A decrease in one or more of savings, taxes, and import spending

• An increase in consumption results in a right shift in the AD curve• The result is an increase in the equilibirum level of prices, real GDP,

and employment

• A decrease in consumption results in a left shift in the AD curve• Decrease in equilibirum level of prices, real GDP, and employment


Changes in investment• The overall level of investment spending is related

to the expectation of future profits• If business profits are expected to increase and

the economic climate looks strong, investment will increase and the AD curve will shift to the right

• If businesses foresee a downturn in economic profits, investment will decrease and the AD curve will shift to the left


• These movements are also closely tied to interest rate• Any investment is likely to necessitate the borrowing

of funds• If the interest rate goes up, the costs associated with the

investment also go up• This would reduce the potential for profit

• Increases in interest rates also tend to reduce investment spending, shifting the AD curve to the left

• Decreases in interest rates have the opposite effect


Changes in government spending• If a government increases its spending or

transfer payments, the AD curve will shift right

• If a government reduces spending, the AD curve will shift left

• These changes are at the heart of fiscal policy and will be discussed later in the chapter


Changes in export demand (foreign trade)

• There are three major factors influencing demand for Canadian-produced exports:• The domestic rate of inflation• The relative levels of income in other

countries• The value of the Canadian dollar


• Inflation (or a general increase in the level of prices) affects only domestic and not foreign goods and services• A general increase in the price of Canadian goods and

services makes them more expensive than foreign-made goods and services

• A rapid rise in inflation will reduce export demand• Foreign consumers will buy fewer Canadian products

• A decline in the rate of inflation will make Canadian goods less expensive and increase export demand


• A similar effect will occur as the income levels rise for consumers in countries that are trading partners

• Their demand for goods will increase and Canadian exports to these countries will rise

• The opposite will occur for a decrease in the level of foreign incomes


• Increases in the value of the Canadian dollar will increase the cost of Canadian products for foreign consumers• An increase in the value of the Canadian dollar

can translate into a decrease in AD because we are selling fewer exports

• Decreases in the value of the collar make the relative price of Canadian products cheaper for foreign consumers, thus increasing AD

Changes in Aggregate Supply

• Just as events in the marketplace can shift the AD curve, the AS curve is subject to shifts as well

• There are three reasons why the AS curve might shift:• A change in the price of any of the basic

inputs (land labour, and capital)• A change in the amount of basic inputs

available• A change in the efficiency of the production

process


Changes in price of inputs• If the prices for land, labour, or capital increase, firms

will produce less at each price level• The AS curve will shift upward and to the left at all points

to the left of its perfectly inelastic section• The perfectly inelastic section will not move because, while

prices are higher, the same amount of inputs are available• Therefore, the maximum real GDP possible is the same as it

was before the price increases

• Decreases in the price of inputs will shift the AS curve downward


Changes in the amount of inputs available• If new resources are discovered, more capital

goods are made available, or the workspace grows, there are more inputs available for use

• Just as these changes would shift the production possibilities curve outward, they would increase the maximum capacity of the economy

• The availability of more resources also reduced competition for them, pushing down the costs of basic inputs


• The effect of the AS curve is:• To shift the relatively elastic, horizontal portion

downward, reflecting decreases input prices• To shift the vertical portion to the right,

reflecting the increased capacity of the economy


Changes in efficiency• Improvements in technology make the

workforce more productive• As the workforce becomes more efficient, it can

produce more output with the same resources

• The resulting effect on the AS curve is the same as increasing the amount of resources available

• The curve shits downward, with the vertical portion moving farther to the right

The Business Cycle & Aggregate Supply and Demand

• A business cycle covers periods of alternating economic growth and recession (or negative economic growth) as measured by changes in the real GDP• In other words, business cycles are the ups

and downs of the economy

• The duration in time of a business cycle and its size (in loss or gain of real GDP) vary from one cycle to the next


• A business cycle occurs because of the fluctuations that economies experience over time• Result from changes in

economic growth and patterns of consumption

• In the previous section, we explained these changes as shifts of the AD and AS curves


• Business cycles are the heart of macroeconomics• Economists try to determine how well the economy is

doing and where it is heading

• Forecasting the coming economic climate allows economists to advise political and business leaders on how to deal with possible future economic events

• When the economy is heading in an undesirable direction, economists can advise a nation’s leaders to apply fiscal or monetary policy tools to try to change the course of the economy

The Dynamics of the Business Cycle

• The causes of these fluctuations in economic activity are varied

• The cyclical nature of the marketplace is dynamic• It’s not possible to detail all the reasons for

cyclical fluctuations in the economy

• We will now go through how a simple macroeconomic model works


• An expansion period begins when consumer spending increases and production increases• Represented by an upward trend in the business cycle

• Let’s assume the Canadian economy is on an upswing• Unemployment is declining• Business activity is increasing• Increased production

• Increased production leads to new workers being hired• New employment leads to a general rise in consumer

incomes• Generates increased levels of consumption


• Consumer psychology that is influenced by positive economic news can also contribute to increased spending

• Increased spending translates into an increase in aggregate demand for goods and services• This leads to an higher levels of output and employment

as well as higher prices

• This higher demand leads to increased production, more workers being hired, and the cycle starts again• This prosperity cycle is the result of aggregate demand

feeding itself


• It looks like, as long as resources are available, this trend of greater and greater economic expansion should continue

• However, at some point the economy will peak, and then the trend will begin to reverse


• The reasons for the turn-around at the peak of a business cycle are varied

• Consumers may exhaust the purchasing patterns that pushed up aggregate demand• Many of the expensive durable goods (ex: cars,

appliances, new homes) that drive a booming economy don’t need to be replaced very often

• Demand begins to decrease when many consumers’ wants are satisfied


• Sometimes the turnaround is linked to an event• Ex: the stock market crash of 28 Oct 1929• Combined with restrictive trade policies, the

dependence of the resource, and reduced government and investment spending, the result was a huge drop in aggregate demand


• The increase in producers competing for capital funds to support business expansion puts upward pressure on interest rates• As interest rates increase, consumers are less

likely to buy goods for which they need to borrow money• The durable goods that make up 10% of GDP

• If demand shifts too far to the right, it will exceed the economy’s capacity to produce


• If demand shifts too far to the right, it will exceed the economy’s capacity to produce• This will cause more severe inflation• As prices rise, higher inflation levels have the

effect of reducing the real income of consumers

• Demand begins to decline


• Together, these factors have the effect of reversing the direction of shift in the aggregate demand curve• Instead of moving to the right, as it did while

the economy was expanding, it now begins to shift to the left

• This trend is reflected in the recessionary part of the business cycle, which slopes downward


• The prosperity cycle begins to reverse as we move past the peak of the business cycle

• Reduced demand for domestic goods leads to firms being overstocked with goods• An increase in good surplus indicates to firms that they

should cut back production

• Production cutbacks lead to worker layoffs, which lead to lower incomes

• Decreased incomes lead to a decrease in consumer demand for goods and services, shifting aggregate demand to the left


• If this occurs, the revenues of firms will tend to decline

• Some firms will be forced to cut back production in order to control costs, others may lay off workers, and still other firms that can’t reduce their costs may go out of business

• When this type of downward spiral in economic activity occurs, it is called a recessionary trend


• Officially, a recession occurs when real GDP growth is negative, or declines for two consecutive quarters (three-month periods)

• The recessionary, or contractionary, part of the business cycle is characterized by:• Increasing unemployment• Low (or negative) levels of real

GDP growth• Low levels of inflation or even

falling prices (deflation)


• The recessionary period is influenced heavily by consumer psychology

• Media reports of layoffs (and the threat of more layoffs) cause people who still have jobs to decrease their consumption spending

• Sometimes people begin to save in order to provide a “cushion” in case they are laid off

• Others may cut back on the purchase of “big ticket” durable goods, fearing to increase their debt load when wage increases are unlikely and loss of income is possible


• These changes in the level of consumption spending make the recessionary period worse• They tend to pull aggregate demand farther to

the left

• If the recessionary period becomes prolonged, with very high unemployment and very low output levels, it is known as a depression


• At some point, events will occur that will stop the downturn in economic activity and will generate increases in consumer spending• Prices may fall to a point where consumers start to spend again,

and the upward movement of the business cycle resumes

• Consumers can postpone the purchase of some items only for a certain length of time• A new car or fridge is bought when it is no longer worthwhile to

repair it• Clothes wear out

• As these purchases occur, inventories of firms begin to dwindle and firms increase production again


• While these regular fluctuations of economic activity occur over varying durations and to varying degrees, over time the level of business activity in an economy tends to increase steadily

Leakages and Injections

• Another explanation of the business cycle centers on the money payments that flow through the economy

• This circular flow of income sees the GDP as a total of all money payments in the economy• Businesses hire individuals from households to work for

them and pay them a wage in exchange• Businesses also pay individuals money through interest

payments on the capital that they borrow for expansion• Individuals, in turn, spend the money that they earn on

goods and service that the businesses produce• This simplified circular flow model can be seen highlighted

in green in Figure 10.11


• Leakages are any uses of income that cause money to be taken out of the income-expenditure stream of the economy

• The income generated by production is subject to three leakages as it is returning to generate more production:• Taxes (T)• Savings (S)• Imports (M)

• The amount of each of these leakages will rise and fall with the level of production


• “Leaked” money often ends up getting re-spent in the economy• The problem is where and how

• Governments might spend the money they take in taxes• But they might also spend more or less than the amount they

actually receive in tax revenues

• Other countries’ export earnings might be used to purchase imports• But there is no guarantee that trade will be balanced, or that they

will purchase Canadian goods

• The money we save might be borrowed for business investment inside Canada• But then again, it might not


• An injection is any expenditure that causes money to be put into the income-expenditure stream

• The three major injections into the economy are:• Government spending (G)• Investment spending (I)• Exports (X)

• Consumption is NOT an injection• Consumer incomes are disposed of through consumption,

taxes, savings, and import spending• If leakages are going up, they reduce consumption spending• If leakages are going down, they help increase such spending


• The relationships between the three leakages and three injections determine whether the overall demand is growing or shrinking

• If leakages > injections = aggregate demand will shrink• But as production falls, consumers will pay fewer taxes,

save less, and buy fewer imported goods, causing leakages to fall

• When the leakages falls to the level of the injections, the economy generally stops shrinking• The economy is in equilibirum


• The equilibrium may be:• Below full employment (a recessionary gap)• At full employment• Above full employment (a inflationary gap)


• If injections > leakages = aggregate demand will grow• But as production and incomes rise, so do

taxes, savings and imports, causing leakages to grow

• When leakages are as large as injections, growth will stop• Once again, this may be at, above, or below

full-employment equilibrium


• Some have compared this model to filling a bathtub• If the amount of water coming in (injection) is

greater than the amount going down the drain (leakage), the bathtub fills up (the GDP gets bigger)

• If the amount of water coming in is less than the amount leaking out, the bathtub empties (the GDP shrinks)

• If the water coming in and the water leaking out are equal, the amount of water in the tub remains the same (equilibrium)


• This model can be expressed as a formula (see board)

Fiscal Policy

• Most mixed economies go through upheavals caused by the ups and downs of the business cycle

• Should we as a society do anything about these economic booms and recessions, or should we let the market make its own adjustments?

Fiscal Policy• John Maynard Keynes

believed that the business cycle should be managed• Advocated government

intervention

• Governments intervene in the economy through the use of stabilization policies• One way that a government

can intervene is through applying the tools of fiscal policy

Keynes’s Ideas

• By examining the relationships between demand and income, Keynes was able to explain the Great Depression in a way that classical economists could not

• A collapse of investment spending brought consumer spending down with it• With low levels of consumer spending, it was

unlikely investment spending would recover• Ex: An auto company that is running at only 50%

capacity has no reason to build new factories

Keynes’s Ideas

• But Keynes’s ideas went far beyond simply explaining depressions and recessions

• If government policy could affect the sizes of leakages (taxes, savings, and imports) and injections (investment spending, government spending, and exports), aggregate demand could be managed

Keynes’s Ideas• Aggregate demand could be purposely increased

in a recession or depression and purposely reduced when excessive demand was leading to inflation

• This was a revolutionary way of thinking that would influence economic thought for the rest of the 20th century• Ex: the stock market fell in 1987 much more rapidly

than it did in 1929, but the rate of economic growth was not greatly affected, partly because governments applied Keynesian theory

Keynes’s Ideas

• Government policies to mange aggregate demand fall into three areas• Fiscal policy• Monetary policy• Trade policy

The Basics of Fiscal Policy

• Fiscal policy is the use by a government of its powers of expenditure, taxation, and borrowing to alter the size of the circular flow of income in the economy so as to bring about:• Greater consumer demand• More employment• Inflationary restraint• Other economic goals

The Basics of Fiscal Policy

• If private spending is too small…• Government can increase aggregate demand by increasing

its own spending or by encouraging private spending

• If private spending is too large…• Government can reduce aggregate demand by decreasing

its own spending or by discouraging private spending

• When the government takes deliberate actions through legislation to alter spending or taxation policies in order to influence the level of spending and employment, it is called discretionary fiscal policy

Expansionary Policy• When the economy is in a

recession:• Aggregate demand is low• Unemployment is high• There is little, or negative,

growth in output

• The government may wish to increase aggregate demand by using an expansionary fiscal policy• This would entail a tax cut, an

increase in government spending, or both, to stimulate economic growth and lower unemployment rates

Expansionary Policy• If the government cut taxes, it would increase

the disposable income of consumers• Assuming the consumers didn’t save this

increase or spend it on imports, they would increase the aggregate demand in the economy through consumption

• The shift in aggregate demand would lead to both an increase in employment and an increase in the growth of GDP as the equilibrium moved closer to full-employment output• As long as the equilibrium remained below full-

employment equilibrium, there would be little increase in the general level of prices

Expansionary Policy• The same stimulation of

aggregate demand would occur (but for different reasons) if the government used increased government spending as their expansionary policy

• Government spending is one of the four components of GDP, and therefore, of aggregate demand

• An increase in government spending would directly shift the aggregate demand curve to the right through the G portion of the GDP equation

Expansionary Policy• The influence of government spending on

aggregate demand is direct• A reduction in taxes requires consumers to follow

through by spending their increase in income, which they may choose not to do• If they choose not to increase consumption,

aggregate demand will not increase

• Because an increase in government spending acts directly on aggregate demand, there is no risk that the policy will not have the desired effect

Expansionary Policy

• If the government wanted to maximize the effect of its expansionary policy, it could use both a tax cut and a spending increase in order to stimulate aggregate demand as much as possible

Contractionary Policy• When the economy is

suffering from inflation:• Aggregate demand is too high• Employment is high• There is high growth in output

• The government may wish to decrease aggregate demand by using contractionary fiscal policy• This would entail a tax

increase, a decrease in government spending, or both to reduce upward pressure on prices

Contractionary Policy• If the government increased taxes…• This would effectively decrease the disposable income of

consumers• In turn, this would decrease the aggregate demand in the

economy through the C (consumption) portion of the GDP equation

• The shift in aggregate demand would lead to a decrease in the inflation rate

• However, the decrease would also have the trade-off of lowering GDP and employment levels as equilibrium moved back toward full-employment equilibrium

Contractionary Policy• The government could also address the problem

by altering its spending• A reduction in government spending would reduce

aggregate demand

• As in expansionary policy, using both would increase the overall effect

• The overall goal of expansionary and contractionary fiscal policy (known as fiscal stabilization policy) is to smooth out the ups and downs of the business cycle

Tools of Fiscal Policy

Changes in spending• The government can stimulate the economy

by increasing general spending in all areas of its programs• Health and welfare• Culture• Education• Etc.

Tools of Fiscal Policy• It can also undertake infrastructure programs• Infrastructure is the underlying economic foundation of

goods and services that allows a society to operate

• These programs might include building:• Roads• Hospitals• Schools• Communications systems (Ex: laying fiber-optic cable)

• The added advantage of that they add to the stock of capital goods and• Promote the outward shift of the production possibilities curve

Tools of Fiscal PolicyChanges in taxation• To restrain or stimulate economic activity, the

government can change the amount of tax it collects• This can be accomplished through a number of options:• Raise or lower personal and corporate income taxes and/or

sales and excise taxes• Alter tax exemptions or tax credits• Provide special tax incentives for investments, such as

larger capital cost allowances on new buildings and equipment• This would influence aggregate demand through the I portion of

the GDP equation

Tools of Fiscal PolicyAutomatic stabilizers• We have looked at discretionary fiscal policies, which

require the government to make specific decisions to implements necessary changes to its spending and taxation policies

• Automatic stabilizers already exist and are acting on aggregate demand before a recession or inflationary trend takes hold• Mechanisms built into the economy that automatically

increase or decrease aggregate demand when needed• Require absolutely no direct actions or legislation by policy

markers because they are already legislated

Tools of Fiscal Policy• Employment insurance and welfare are automatic stabilizers• During periods of economic downturn, Employment Insurance

payments increase as more people become unemployed• Since unemployment increases during recessionary periods,

Employment Insurance payments help to maintain incomes and, thus, the consumption portion of GDP

• If the recessionary period is prolonged, the number of people on welfare rolls also increases• The purpose of welfare is to ensure people a level of income so

that they can survive• But these payments also help to increase consumption• This either slows the leftward shift of the AD curve or begin to

increase AD

Tools of Fiscal Policy• Another common type of automatic stabilizer is tax rates

that vary with levels of income• A progressive tax acts as a stabilizer in that:• It rises as incomes rise• It has the effect of increasing a leakage as incomes grow

• At lower levels of income, the tax rate may be 20%• But as a person’s income rises, it may start to be taxed at 30%

• These increases in tax slow down the increase in consumption• Stop the aggregate demand curve from shifting too quickly to

the right, which could lead to inflation

Tools of Fiscal Policy

• It is important to note that these is also a discretionary element to automatic stabilizers

• At any time, the government may make a decision to change the level of spending or taxation

• When these changes are made, they are considered discretionary fiscal measures

Government Budget Options

• Governments in Canada usually announce their changes in revenue and spending plans in the spring by outlining the coming year’s budget

• In establishing their budget, the government can end up in one of three situations:


• Deficit budget• Occurs when the government spends more than it

collects in tax revenue• It must borrow they money to cover the shortfall

• Surplus budget• Occurs when the government collects more in tax

revenue than it spends• Consequently, it has money left over

• Balanced budget• Results when the government spends an amount equal to

what it has collected in tax revenue


• The debt is the total amount that a government owes on money it has borrowed to fund deficit budgets

• Ex: A government spends $150 billion in year 1 but takes in only $130 billion in revenues• It has a shortfall, or budget deficit, of $20 billion• It must borrow $20 billion• In year 2, the government spends $150 billion (including

interest on the debt from Year 1) and takes in $140 billion in revenues

• It has a deficit of $10 billion and an accumulated debt of $30 billion ($20 billion from year 1 and $10 billion from year 2)

Drawbacks and Limitations of Fiscal Policy

• The time lags that exist in utilizing fiscal policy are significant• Recognition lag = The time the government takes to

recognize a problem in the economy• Decision lag = The time required for the government to

determine the most appropriate policy• Implementation lag = Once the decision has been

made, various government departments have to figure out just how to implement the new directives regarding spending and taxation

• Impact lag = Once the policy is in place, time is required before its full effects can be felt through the multiplier effect


• The government might have difficulty changing spending and taxation policies• Raising taxes is often unpopular• Cutting spending may be impossible if there

are long-term contracts or the programs are very popular with citizens

• The timing of government elections may also influence spending and taxation policies


• Conflict between the various levels of government regarding the appropriate fiscal policy might limit effectiveness• If the federal government is reducing spending

and increasing taxes in an effort to slow down economic growth and a powerful provincial government is increasing spending and cutting taxes in order to gain political support, the two policies may offset each other


• Regional variations may exist that interfere with the implementation of fiscal policy• If part of the country is doing well while

another region is suffering from a slowdown, what policy should be used?

• An expansionary policy would likely cause inflation in the region doing well, yet a contradictory policy would make the recession worse in the part of the country suffering a slowdown


• The size of the debt can also limit the use of fiscal policy as an effective tool• In recent years, the federal debt in Canada has

grown so large that there is much political pressure not to increase it further

• If expansionary policy were desired, the government would have little room to increase spending and cut taxes without increasing the debt

• The federal government and most provincial governments made deficit reduction the primary focus of fiscal policy during the late 1990s


• Some economists believe that a crowding out of private investment occurs when the government competes with the private sector to borrow funds to finance the debt• Argue that this policy drives up interest rates

and reduces the amount available for private investment

• As a result, investment in capital goods decreases and the rate of economic growth slows

Unit 3: Macroeconomics

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Transcript of Unit 3: Macroeconomics