IBDP Economics - Macro - Fiscal Policy

1. FISCAL POLICY
IB ECONOMICS

2. MACRO-ECONOMIC OBJECTIVES
 Employment levels -> High
 Price levels -> Stable
 Output of G/S -> Increases Over time
 NI -> Distributed in an equitable manner.
To Achieve Macro-economic objectives:
Macro-economic policies:
 Fiscal Policy
 Monetary Policy
 Supply-side policies

3. FISCAL POLICY
 Govt changes level of Taxation and/or level
of Govt Spending. Promote ->
Macroeconomic obj.
•Y-> Y(FE) -> Full
employment
•P-> Pe -> Stable
price level
•Increasing rGDP. -
> Economic growth

4. DEFICITS, SURPLUS AND DEBTS
 Govt tot expenditure exceed total tax revenue ->
Budget Deficit
 Deficit paid -> Borrowing from public (Explored
in further chapters).
 When govt borrow -> National Debt
(Accumulation of deficits from past
years)increases.
 Govt tax revenue exceeds expenditure ->
Budget Surplus -> Reduces national debt
 Tax revenue = Govt expenditure -> Balanced
budget

5. AUTOMATIC FISCAL POLICY
 Tax and govt spending s/ms -> element of
bui;t in stability.
 Increase in GDP -> Decrease in G and
Increase in T
 Decrease in GDP -> Increase in G and
Decrease in T

6. PERIODS OF ECONOMICS GROWTH:
 Y> Yfe, unemp->low, households and firms
income and revenues-> high, Decrease in govt’s
expenditures on certain items. Few ppl
collecting benefits -> unemp, welfare,
subsidized food etc..
 Healthcare -> provided by public n pvt, unemp -
> low, govt spend less on healthcare. Employers
cover health benefits.
 Growth in a nation’s GDP -> Increase tax
revenues due in increased income and
expenditure by households and firms.

7. DISCRETIONARY FISCAL POLICY
 At the discretion (Decision of policy makers).
 Change in T and G undertaken by govt with
the explicit aim of either stimulating /
contracting the overall level of Demand in the
economy to promote Economic stabilty and
full employment

8.  Increase level of AD/AS -> Expansionary
Fiscal Policy
 Decrease level of AD/AS -> Conntractionary
Fiscal policy
 Expansion:
Increase AD, By Decreasing Taxes and
Increasing Govt Spending
 Contraction:
Decrease AD, By Increasing Taxes and
Decreasing Govt Spending

9. EXPANSIONARY FISCAL POLICY
 Dec in Consumption
and Income ->
Decrease in AD
 Price levels -> Come
down (Deflation).
 Decrease in National
O/P -> Recession ->
Increased
Unemployment.
 Govt needs to intervene.

10. EXPANSIONARY FISCAL POLICY
 Decrease Taxes:
Decrease IT -> Increase Disposable Income ->
Increase C -> Increase AD
 Increase Govt Spending (G):
Increase Public goods, defence, edn and
healthcare, Increase AD
After –Effects:
 Price Levels Increase -> Stable
 Increase O/P -> Full employment
 Unemp Decreases.

11. CONTRACTIONARY FISCAL POLICY
 Depreciation of
currency-> decrease
exch rate-> Exports (X)
Increase -> Imports (M)
Decrease
 (X-M) Increase -> AD
Increase
 Demand-pull inflation –
price levels rise->
Inflationary gap.
 Output goes beyond full
employment with
resources becoming
scarce. Unemp
unnaturally low

12. CONTRACTIONARY FISCAL POLICY
 Increase Taxes
Increase IT -> Decrease Disposable Income-> C
Decreases -> Decrease in AD
 Decrease G
Reduce public goods, defence -> AD Decreases.
After-Effects:
 Price levels Come down -> Stable
 O/P Reduces and comes to full employment
level.
 Unemployment Increases to the desirable state.

13. THE MULTIPLIER EFFECT: HL
 THE GOVT
SPENDING
MULTIPLIER (The
Keynesian
Spending
Multiplier):
 Recessionary Gap,
 Y < Yfe, P2 < P1 –
Deflation
 Expansionary: Inc G
and Dec T

14. THE GOVT SPENDING MULTIPLIER (THE
KEYNESIAN SPENDING MULTIPLIER):
 Increase in G -> Increase in AD (How many
times).
 G-> Multiplied greater expansionary effect on
AD
 Eg. If G inc by $ 1b, AD Inc by $ 4b
  Multiplier of 4
Depends on Macroecon variables –
Marginap Propensity to Save and Consume
Households -> Either Spend/Save any change
in Income

15. MARGINAL PROPENSITY TO CONSUME
 MPC  ∆C
∆Y
Changes in G -> Changes in o/p
G inc by $1b -> Y inc by $1b
C Inc by $ 400 m
MPC  400/1000 = 0.4
If there’s a inc in Y of $1  Consumption
increases by 40 cents.

16. MARGINAL RATE OF LEAKAGE (MRL)
 MRL = MPS + MPM + MRT
 MPS -> Marginal propensity to Save (∆S/∆Y)
 MPM -> Marginal propensity to Imports (∆M/∆Y)
 MRT -> Marginal Rate of Tax(∆T/∆Y)
 MRL  Proportion of Income that goes into
purchase of Leakages(Imports, Savings, Taxes).
 MPC + MRL =1
 MRL = 1-MPC
 Above eg: MRL = 1-0.4 = 0.6

17. THE KEYNESIAN GOVT SPENDING MULTIPLIER
(K)
 K = 1 = 1
1-MPC MRL
Larger the MPC, Larger the value of K,
Above eg, MPC = 0.4, MRL =0.6, K = 1.67
Inc in G  Increases AD by 1.67 times
Eg. If G increases by $ 1b -> AD will Increase
by K(∆G) => 1.67 * $1b => $1.67b

18. ILLUSTRATION
Take before example
Recessionary gap is $ 5b.
AD increases by $ 1.67b doesn’t cover
the Gap
To Cover Gap, AD should increase by $
5b
∆G * K = ∆AD
If ∆AD = $ 5b, ∆G => $ 5b/ K = $ 3b
Hence, To fill the gap of $ 5b -> G should
increase by $ 3b, Higher Fiscal Stimulus
Fiscal Stimulus:
How much should G be changed to
cover the gap of recession.

19. K MPC MRL
Larger Higher Smaller
Smaller Lower Higher
Evaluation of Fiscal policy:
•Govt Spending Vs tax cuts
Reduction in T of a particular amount is less effective at
Increasing NI than Increasing G
G  direct injunction into circular flow of income. Tax cut is
an indirect injunction into the circular flow of income
Instead of G spending, govt cuts taxes by $ 3b=> MPC ->
0.6 of $ 3b  $ 1.8 b will convert to new spending in the
economy, rem 40% ($ 1.2b)leaked from the system
(savings, purchase of imports)
Hence AD will increase by 1.67 * $ 1.8b => $ 3b having still
a recession gap of (5-3) => $ 2b

20. STRENGTHS & WEAKNESSES OF FISCAL POLICY
 The crowding-out effect:
The effect of pvt consumption and investment
of a deficit-financed increase in govt
spending that leads to increase in interest
rates
i.e. When G inc -> Govt borrowing from pvt Inc
-> Drive up interest rates.
Inc in AD intended thro fiscal stimulus ->
crowded out by simultaneous Dec in
Consumption and Investment.

21.  Nations’ s loanable funds
mkt-> Money in Commercial
banks that is available to be
loaned out to firms &
households to finance pvt
investment and
consumption.
 Price of loanable funds ->
Real interest rate
 Real returns on savings and
real price on borrowings. Pvt
sector’s willingness to save
and invest
 Supply curve -> savings,
Demand curve ->
Investment.

22.  Higher real interest, Increase savings ->
more ROR. Direct relationship between real
interest & supply of loanable funds
 At lower interest rates, households & firms
borrow and spend Demand for loanable
funds reflect inverse relationship b/w QD and
real interest rates.