Fiscal Policy

Classical 

• Competition is good
• In the long-run, the economy will balance at or near full employment
• Invisible Hand - no government intervention 
• Trickle Down Effect - help rich first, then everybody else

Keynesian 

• Competition is flawed
• In the long-run, we are all dead
• The economy is not always at or near full-employment 

Fiscal Policy 

• Changes in the expenditures or tax revenues of the federal government 
• 2 Tools of Fiscal Policy:
• Taxes - Government can increase or decrease
• Spending - Government can increase or decrease
• Enacted to promote our nation's economic goals: full employment, price stability, economic growth
• If Taxes Increase, Spending Increases; vice versa

Deficits, Surpluses, Debts

• Balanced Budget
• Revenue = Expenditures
• Budget Deficit
• Revenue < Expenditures
• Budget Surplus
• Revenues > Expeditures
• Government Debt:
• (Sum of all deficits - Sum of all surpluses)

• Government must borrow money when it runs a budget deficit
• Government borrows from
• Individuals
• Corporations
• Financial Institutions
• Foreign Entities or Foreign Governments 

Fiscal Policy Two Options

• Discretionary Fiscal Policy (action) 
• Expansionary fiscal policy - think deficit
• Contractionary fiscal policy - think surplus
• Non-Discretionary Fiscal Policy (no action)

Discretionary and Automatic Fiscal Policies

Discretionary:

• Increasing or decreasing government spending and/or taxes in order to return the economy to full employment
• Policy involves makers 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 policy makers having to respond to current economic problems

Contractionary and Expansionary Fiscal Policy

• Contractionary Fiscal Policy - policy designed to decrease aggregate demand
• Strategy for controlling inflation

• Expansionary Fiscal Policy - policy designed to increase aggregate demand
• Strategy for increasing GDP, combating a recession, and reducing unemployment

Expansionary Fiscal Policy

• Recession is countered with expansionary policy
• increase government spending (G ↑)
• decrease taxes (T↓)

Contractionary Fiscal Policy 

• Inflation is countered with contractionary fiscal policy
• Decrease in government spending (G↓)
• Increase taxes (T↑)

Automatic or Built-In Stabilizers

• Anything that occurs without government regulation
• Anything that increases the government's budget deficit during a recession and increases its budget surplus during an inflation without requiring explicit action by policy makers

Automatic Stabilizers

1. Transfer payments 
2. Welfare checks
3. Food stamps
4. Unemployment checks
5. Corporate dividends
6. Social security
7. Veterans benefits 

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

Consumption and Savings

Disposable Income ( DI ):

• Income after taxes or net income

2 Choices:

• With disposable income, households can either:
• Consume (Spend)
• Save (Not Spend)

Consumption:

• Household spending
• The ability to consume is constrained by:
• the amount of disposable income 
• the propensity to save
• Do households consume if DI = 0?
• autonomous consumption
• dissavings

Savings: 

• Household NOT spending
• The ability to save is constrained by:
• the amount of disposable income
• the propensity to consume
• Households do not save if DI = 0 

MPC & MPS 

Marginal Propensity to Consume (MPC)

• MPC = ⧍C/⧍DI
• % of every extra dollar earned that is spent

Marginal Propensity to Save (MPS)

• MPS = ⧍S/⧍DI
• % of every extra dollar earned that is saved

Multiplier are (+) when there is an increase in spending; (-) when there is a decrease

Calculating the Tax Multiplier

• When the government taxes, the multiplier works in reverse 
• Money leaving circular flow 

Tax Multiplier (Negative)

• - MPC / 1 - MPC
• - MPC / MPS

If there is a tax cut, then the multiplier is positive, more money in circular flow

Interest Rates and Investment Demand

What is an Investment?

• Money Spent or Expenditures on:
• New Plants (Factories)
• Capital Equipment (Machinery)
• Technology (Hardware & Software)
• New Homes
• Inventories (Goods Sold by Producers)

Expected Rates of Return 

• How does business make investment decisions?
• Cost/Benefit Analysis

• How does business determine the benefits?
• Expected Rate of Return

• How does business count the cost?
• Interest Costs

• How does business determine the amount of investment they undertake?
• Compare Expected Rate of Return to Interest Cost
• If Expected Return > Interest Cost; Invest
• If Expected Return < Interest Cost; Do NOT Invest

Nominal ( i % ) - Observable Rate of Interest

Real ( r % ) - Subtracts out Inflation and is known as post-facto

Real Interest Rate ( r %  = i % - π % )

What determines the cost of an investment decision? The Real Interest Rate (r%)

• When interest rates are high; fewer investments are profitable, vice versa.
• Conversely, there are few investments that yield high rates of return, and many that yield low rates of return