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Chap_16_-_Fiscal_Policy_part_2_[1]

# Chap_16_-_Fiscal_Policy_part_2_[1] - Fiscal Policy(cont...

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Fiscal Policy (cont.) Fiscal policy can also be used to target the aggregate demand curve to keep real GDP as close to potential GDP as possible. There are certain fiscal actions that change automatically with the state of the economy that help keep real GDP close to potential GDP. These are called automatic stabilizers . Once example of an automatic stabilizer is that when real GDP decreases, more people get unemployment benefits. This helps to increase consumption, which helps to increase real GDP, which keeps the aggregate demand curve from shifting as far to the left as it would otherwise. Medicaid, and food stamps are other examples of automatic stabilizers. A less obvious automatic stabilizer is taxes. If you remember, the in a world without taxes (and trade, and price changes) the multiplier equals: multiplier = 1 1 MPC however, we said that in the real world, the multiplier is always smaller than this. The main reason for this is that taxes reduce the multiplier. This can actually be a good thing. Most recessions are caused by negative demand shocks. Because the multiplier is actually less than 1 1 MPC , these shocks are not quite as severe. For example, in the United States, currently the MPC equals about .6, while the multiplier is about 1.9. Now lets say that there is a negative demand shock, and businesses decide to invest \$200 billion less. If there were no taxes that would mean that the aggregate demand curve would move: 1 1 MPC × Δ AAS = 1 1 .6 × − \$200 billion = 2.5 × − \$200 billion = \$500 billion or \$500 billion to the left. However, since the actual multiplier is less than 2.5, the aggregate demand curve will only move: 1.9 × -\$200 billion = -\$380 billion or \$380 billion to the left. Discretionary fiscal policy A discretionary fiscal policy is a fiscal policy that is the direct result of deliberate actions by policy makers rather than automatic adjustment. The Bush tax cuts or the recent stimulus package are two examples of discretionary fiscal policy. Remember that GDP = C + I + G + NX

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As such, most fiscal policy attempts to shift the aggregate demand curve either by changing the level of consumption, or by changing the level of government expenditures. The government can affect consumption levels in one of two ways. It can change the level of government transfers, or it can change the level of taxes. If government increases transfers then people’s disposable income will increase, leading to an increase in consumption. If the government decreases transfers then people’s disposable income will decrease, leading to a decrease in consumption. Similarly, if the government decreases taxes, then people’s disposable income increases, leading to an increase in consumption. And if the government increases taxes, people’s disposable income decreases, and consumption decreases.
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