Week 10, Day 2 - Chapter 12 Overheads (revised)

Week 10, Day 2 - Chapter 12 Overheads (revised) - Chapter...

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Chapter 12 – Fiscal Policy Discretionary Fiscal Policy vs Automatic Stabilizers Limitations of Discretionary Fiscal Policy Fiscal Policy and the Multiplier Algebraic Model of the Economy (with Taxes) The Budget Balance Cyclically Adjusted Budget Balance Balanced Budget Legislation Long-Run Implications of Fiscal Policy Government plays a significant role in the economy. Canada has 3 major levels of government, each with its own responsibilities: Federal government (national defense, international trade, external affairs, criminal law, employment insurance (EI) and the Canada Pension Plan (CPP)); Provincial governments (health care, education, social services including welfare, natural resources, and property rights); Municipal governments (transportation, public health, fire and police services, water, sewage, and garbage. A vertical fiscal imbalance exists in Canada. The greatest government revenue growth is occurring federally while the greatest growth in government spending is occurring at the provincial level (and to some degree at the municipal level). Discretionary Fiscal Policy vs Automatic Stabilizers The appropriate fiscal policies for dealing with recessionary and inflationary gaps that we examined in chapter 10 were discretionary fiscal policies that required deliberate actions by government such as the implementing a purchase or changing the rules governing transfers or taxes. Another type of fiscal policy is automatic stabilizers; the amounts of taxes and transfers change automatically as a result of changes in the economy’s performance and help to reduce fluctuations in the business cycle. For example, when real GDP and income decline, the amount of taxes collected automatically decrease. When more people become unemployed, the amount of transfers (such as EI and welfare) paid out automatically increase.
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The distinction between discretionary fiscal policy and automatic stabilizers can be illustrated by the tax function, an equation that relates aggregate income (Y) to total tax revenues (T): T = T 0 + tY (eg T = 24 + .3Y). T 0 represents the portion of T that does not depend on GDP (ie lump-sum taxes). The term tY represents the portion of T that depends on Y, and t is the tax rate on income. If T changes because the government alters T 0 or t, the change in T is the result of discretionary fiscal policy. If T changes because Y is changing, the change in T is the result of automatic stabilizers. Looking strictly at T, it is unclear whether discretionary fiscal policy or automatic stabilizers have changed. Q: A shift of the tax function shows the operation of ________ (discretionary policy, automatic stabilizers). A movement along the tax function shows the operation of (discretionary policy, automatic stabilizers). A: discretionary policy, automatic stabilizers Limitations of Discretionary Fiscal Policy As examined earlier, the appropriate discretionary fiscal policies for eliminating a recessionary gap are: an increase in government purchases, an increase in transfers to encourage more consumer spending, and
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