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Chapter 29 - Fiscal policy. After studying this chapter you will be able to understand: What the difference is between contractionary and expansionary fiscal policy? How fiscal policy can counteract short-run fluctuations? What challenges are associated with fiscal policies?. | Chapter 29 Fiscal Policy © 2014 by McGraw-Hill Education 1 What will you learn in this chapter? • What the difference is between contractionary and expansionary fiscal policy. • How fiscal policy can counteract short-run fluctuations. • What challenges are associated with fiscal policies. • How to calculate the fiscal multiplier. • How revenue and spending determine a government budget. • What the difference is between government deficit and debt. • What the costs and benefits of government debt are. © 2014 by McGraw-Hill Education 2 Fiscal policy • Fiscal policy refers to government decisions about the level of taxation or government spending. • Fiscal policy affects the economy by influencing aggregate demand (AD). – Government spending. – Tax policies directly affect consumption, which impacts AD. © 2014 by McGraw-Hill Education 3 1 Fiscal policy Fiscal policy can be either expansionary or contractionary. • Increased government spending and lower taxes have expansionary effects. • Decreased government spending and higher taxes have contractionary effects. Price level Price level LRAS LRAS SRAS SRAS P1 P2 P2 P1 AD1 AD2 Y1 AD2 AD1 Output Y2 • Expansionary fiscal policy shifts the AD curve to the right. Y2 Y1 Output • Contractionary fiscal policy shifts the AD curve to the left. – Output increases. – Prices increase. – Output decreases. – Prices decrease. © 2014 by McGraw-Hill Education 4 Policy response to economic fluctuations • Policy-makers try to use fiscal policy to smooth fluctuations in the economy. • The AD/AS model illustrates how fiscal policy can counteract the effects of economic shocks. – The model predicts that the economy can automatically correct itself. – Lawmakers often intervene because automatic correction can be a painful and slow process. © 2014 by McGraw-Hill Education 5 Expansionary policy responses Expansionary policy can counteract decreases in AD. Initial market response to fall in AD Price .
