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Economics 12407 - Economics Fiscal Policy Deficits and Debt...

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Economics Fiscal Policy, Deficits, and Debt December 4, 2007 Fiscal Policy and the AD-AS Model This fiscal policy is DISCRETIONARY (Active). It is initiated on the advice of the president’s Council of Economic Advisors. Discretionary changes are at the option of the federal government. They do not occur automatically. Expansionary Fiscal Policy When RECESSION occurs, EXPANSIONARY FISCAL POLICY may be in order. The cause of recession may be that profit expectations of investment projects have dimmed, curtailing investment spending and reducing aggregate demand. Three fiscal policy options the government has to stimulate the economy: 1) Increase government spending 2) Reduce taxes 3) Use a combination of the two Increase government spending: A sufficient increase in government spending will shift the economy’s aggregate demand curve to the right. Through the multiplier effect, the aggregate demand curve shifts to a distance that exceeds the initial monetary increase. The greater shit occurs because the multiplier process magnifies the initial change in spending into successive rounds of new consumption spending. Tax Reductions: The government could reduce taxes to shift the aggregate demand curve to the right. The government cutting personal income taxes would increase disposable income by the same amount. Consumption would rise and savings would increase. The multiplier increases the results. Employment rises accordingly to the amount of spending. The smaller the MPC, the greater the tax cut needed to accomplish a specific initial increase in consumption and a specific shift in the aggregate demand curve. Combined government spending increases and tax reductions: The government may combine spending increases and tax cuts to produce the desired initial increase in spending and the eventual increase in aggregate demand and real GDP. Contractionary Fiscal Policy When demand-pull inflation occurs, a restrictive or contractionary fiscal policy may help control it. If an increase in investment and net export spending shift the aggregate demand curve to the right, the outcomes are demand-pull inflation.
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