Skip to main content

Macroeconomics: Fiscal Policy and short run effects of fiscal and monetary policies

 

  • Fiscal Policy: government spending and taxation, aimed at expending or contracting the level of macroeconomic activity in a nation.
    • A tax increase (decrease) will raise (lower) households' disposable income, leading to more (less) consumption. Furthermore, firms will increase (decrease) the number of investment as they get to keep a larger (smaller) share of their profits.
    • An increase (decrease) in government spending affects the variable G that defines the aggregate demand. Government spending also leads to a change in household income, affecting the level of consumption.
  • Tax multiplier: just like any multiplier so far, it is just the sum of a converging geometric series:
    • Say the MPC is equal to 70%, then it must be the case that the MPS is 30%. Thus, the tax multiplier, t, is equal to about -2.32. In other words, for every dollar that goes to tax revenue, total spending decreases by about 2.32 dollars.
    • Note that a tax decrease would be negative, and thus have a positive effect on the economy. For example, the government implements a tax cut of 10 million dollars, assuming the same MPC and MPS from the paragraph above, then the total effect is 23.2 million dollars. Then, AD goes up by 23.3 million dollars.
  • As a reminder, the spending multiplier is equal to:
  • Note that since the tax and spending multipliers are both converging geometric series, it must be the case that neither the MPC or the MPS is equal to 1, then we can conclude that m will always be bigger than t.
Short run effects of fiscal and monetary policies:


  • See that a contractionary fiscal (or monetary) policy shifts the AD curve to the left and an expansionary fiscal (or monetary) policy shifts the AD curve to the right.
  • Note that fiscal and monetary polices can also have an effect on the aggregate supply curve.
    • Crowding out effect of expansionary fiscal policy: if the government borrows money in order to increase its spending (or in order to keep the same level of spending given a tax cut), then this causes the interest rate to go up in the private sector. This will ultimately decrease the number of private investment, pushing the aggregate supply curve to the left.
    • An expansionary monetary policy decreases the interest rate for the private sector which then shifts the AS curve to the right. 
    • Note that usually the supply side effect of both the fiscal and monetary policy are usually much smaller than their impact on the aggregate demand. It is often okay to assume that only the AD is affected.

Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 181-191.

Labels:
Location: Boston, MA, USA

Comments

Post a Comment

Popular posts from this blog

Macroeconomics: multiplier and crowding out effects

Multiplier effect: whenever   any of the components of AD increases, the increase in GDP will be greater than the initial increase in expenditures. The impact on GDP of a particular increase in spending depends on the proportion of the new income that is taken out of the system to the proportion that continues to circulate in the economy. The multiplier effect tells us the impact a particular change in one the components of AD will have on the total income (GDP).  Let k denote the spending multiplier, which is a function of MPC and MPS. The larger the marginal propensity to consume, the larger the spending multiplier. Notice that the larger the MPC, the greater the impact a particular change in the spending variables will have on the nation's GDP. The crowding out effect: If government spending increases without an increase in taxes, the government must borrow funds from the private sector to finance its deficit, thereby increasing the interest rate. This increase in interest ...
Post a Comment
Read more

Econometrics: Bivariate population model

Hello I'm finally back from my extended break. I thought that we should start studying Econometrics.  Let's begin by analyzing a simple bivariate regression. Assume that this equation describes the relationship between two variables X and Y. We say that Y is the dependent variable, whereas X is the independent variable. In other words, we assume that Y (the output) depends on X (the input). Epsilon is the error term, it represents other factors that affect Y. The error term must be uncorrelated with the variable X so that we do not need to include them in our regression, and thus the coefficient of X (beta) should not change, even though Epsilon also determines Y.  beta-0 is the constant term. It tells us what would be Y if X=0. beta-1 is the effect on Y if X changes by one unit. To see this, assume X=education is a continuous function, let's take the derivative of Y=wage with respect to X: Thus, if education goes up by one unit, we should expect, on average, wage to go up ...
Post a Comment
Read more

Exercise: short and long run effects of a fiscal policy

  You are in charge of the government budget for the year 2021. You are told that schools and public roads need to be updated, and you estimate an appropriate budget in order to carry out the task. Describe what will happen in the short run to the economy, and what type of inflation do we see? Describe the supply side effect from this policy, explain what happens in the long run. Assume that there is no crowding out effect. First, note that updating public infractures, assuming taxes stay the same, will require an increase in government spending, which will also have an impact on the investment and consumption level in the economy (remember the spending multiplier?). Therefore, the aggregate demand curve will shift to the right. This will cause inflation (i.e positive change in the price level) and a higher output in the short-run.  Note that if we were to assume a large crowding out effect, the short run aggregate supply curve would shift to the left (increase in production c...
Post a Comment
Read more