Two reasons why a government might want to reduce

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Two reasons why a government might want to reduce aggregated demand:oFirst, expansionary fiscal policy creates deficit during recessions. An increase in taxes or a decrease in spending during an economic expansion can work to reduce the budget deficit and pay off some government debt. Example: the US government ran budget surpluses from 1998 to 2001, at the end of an extended period of economic expansion. oSecond, the government might want to reduce aggregated demand if it believes that the economy is expanding beyond its long-run capabilities. Some economiststhen worry that the economy may “overheat” from too much spending, which can lead to inflation.
Countercyclical Fiscal Policy Countercyclical fiscal policy: fiscal policy that seeks to counteract business cycle fluctuations oIt consists of using expansionary policy during economic downturns and contractionary policy during economic expansions.oThe goal is that countercyclical fiscal policy can reduce the fluctuations inherent in a business cycle.Multipliers The tool of fiscal policy are even more powerful than our initial discussion reveals because the initial effects can snowball into further effects. When fiscal policy shifts aggregate demand, some effects are felt immediately. But a large share of the impact occurs later as spending effects ripple throughout the economy. First, familiar concept: For example, if the government uses fiscal policy to increase spending on new roads, the dollars spent on those roads become income to the suppliers of all the resources that go into the production on the roads. New concept: increases in income generally lead to increases in consumption. when a person’s income rises, he or she might save some of this new income but might be just as likely to spend part of it, too. The marginal propensity to consume (MPC) is the portion of additional income that is spent on consumption:oMPC = change in consumption/change in incomeTo determine the total effect on spending from any initial government expenditures, we use a formula known as the spending multiplier. oIt tells us the total impact on spending from an initial change of a given amount, the multiplier depends on the MPC to consume: the greater the MPC, the greaterthe spending multiplier. The formula for the spending multiplier is: M^s = 1/(1-MPC) What are the Shortcomings of Fiscal Policy?Three issues that arise in the application of fiscal policy: time lag, crowding-out, and saving shiftsTime Lags Both fiscal policy and monetary policy are intended to smooth out the economic variations that accompany a business cycle. There are three time lags that accompany policy decisions: recognition lag, implementation lag, and impact lag o1. Recognition lag: In the real world, it is difficult to determine when the economy is turning up or down. GDP data are released quarterly, and the final estimate from each quarter is not known until three months after the period in

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