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Lecture Notes on Principles of Macroeconomics Vijaya Raj Sharma, Ph.D. LECTURE NOTES ON PART III: STABILIZATION POLICY AND OPEN ECONOMY These notes are not edited. They also do not necessarily cover every material that will be discussed in the class. Students are responsible for additional materials discussed in the class. These notes broadly follow the chapters of the textbook - Macroeconomics: Private and Public Choice, by James D. Gwartney, Richard L. Stroup, and Russell S. Sobel, Ninth Edition, Dryden Press, 2000 IX. FISCAL POLICY Chapter 12 1. Fiscal Policy Fiscal policy is the use of government expenditures (G) or taxes as policy tools for the purpose of achieving macroeconomic goals. Note that change in G changes AD. Also change in taxes changes disposable income, thereby consumption and, thus, AD. Budget deficit is the difference between tax revenue of the government and government expenditures. When government purposely plans for a budget deficit, it is called active or planned budget deficit . On the other hand, when budget deficit is not planned but economic downturn causes deficit, it is called passive budget deficit . For the purpose of policy analysis, we focus on active budget deficit. 2. Expansionary and Restrictive Fiscal Policies An increase in government expenditures increases budget deficit, and so does a decrease in taxes, and both increase AD. A decrease in government expenditures decreases budget deficit, and so does an increase in taxes, and both decrease AD. In other words, fiscal policy uses budget deficit as a policy tool. Government increases budget deficit to expand AD during recession; this is
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called expansionary fiscal policy . On the other hand, government decreases budget deficit to contract AD during inflationary period; this is called restrictive fiscal policy . Thus, Keynesian prescription is to follow a counter-cyclical fiscal policy : expansionary policy when the economy is contracting, restrictive policy when it is expanding. 3. Inflation and Restrictive Fiscal Policy Draw a graph to depict inflationary period. Draw an initial long-run equilibrium where LRAS, SRAS, and AD intersect (draw SRAS very flat to the left of full employment and very steep to the right). When AD shifts to the right, the economy goes to an inflationary equilibrium: both output and price level are higher, compared to the initial equilibrium. Classical economists recommend a "do nothing" policy as wages would adjust upwards in the long run, shifting SRAS to the left and reestablishing full employment equilibrium. Keynesians, on the other hand, recommend government to implement a restrictive fiscal policy (decrease budget deficit by reducing government expenditures or increasing taxes) to shift AD back to the initial position.
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