Fiscal policy

Fiscal Policy-
The change in expenditures or tax revenue of the federal government 

can either increase or decrease taxes or spending

Types of Budget
Balanced Budget= Rev. = Expenditures
Deficit= Rev. < Expenditures
-when in deficit, gov't borrows from

1. individuals
2. corporations
3.  financial Institutions
4.  foreign Entities and Countries

Surplus= Rev > Expenditures
Goverment= Sum of deficits - sum of surplus
Discretionary)

• -Expansionary when in deficit
• -combats recession
• -increases gov't spending; decreases taxes
• -Contractionary when in surplus
• -combats inflation
• -decreases gov't spending; increases taxes
• -increase/decrease gov't spending or taxes to get back to FE (fiscal policy responds to economic problems that [may] occur)

Non-Discretionary (wait)
Automatic or built-in stabilizers - include unemployment compensation and marginal taxes; they happen without the use/interference of policy makers

Tax Systems
Progressive- Avg. tax rate rises with GDP (Tax revenue/GDP)
Proportional- Avg. tax rate remains constant as GDP changes
Regressive-Avg. tax rate falls with GDP
More Progressive = More Stablility

Consumption/ Savings

-Disposable income: income after taxes or net income
DI = Gross income - Taxes
-Consumption: household spending, limited by amount of DI, autonomous consumption, dissaving.
-Saving: household not spending, limited by amount of DI, propensity to consume, DI/= 0
-Average Propensity to Consume (APC)
-Average Propensity to Save (APS)

• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 dissaving

-Marginal Propensity to Consume (MPC)
mpc = change in consumption / change in DI

-Marginal Propensity to Save (MPS)
mps = change in savings / change in DI

• MPC + MPS = 1
• MPC = 1 - MPS
• MPS = 1 - MPC

-Spending Multiplier effect: an initial change in spending
change in AD / change in spending  ( C, Ig, G, Xn)     1 / 1 - MPC or 1 / MPS

-Tax Multiplier: when the government taxes the multiplier works in reverse
tax cut = MPC / 1 - MPC   or  -MPC / MPS

SRAS Graphs/ Interest Rates & Investment Demand

Full Employment equilibrium exists where AD intersects SRAS & LRAS at the same point.

Recessionary Gap exists when equilibrium occurs below full employment output.


Inflationary gap exists when equilibrium occurs beyond full employment output.


Notes on SRAS

• -Nominal Wages: (what you make) the amount of money received by a worker per unit of time
• -Real Wages: (how far you can go with $$) the amount of goods and services that a worker can purchase with their nominal wages
• -Sticky Wages: the nominal wage level that is set according to an initial price level and does not vary due to labor, contracts, or other restrictions.
• 
  

Interest Rates & Investment Demand
-What is Investment?
-money spent or expenditures on : new plants, capital equipment (machinery), technology, new homes, inventories (goods sold by producers)

Expected Rates of Return

• How does business make investment decisions?

cost/benefit analysis

• How does business determine benefits?

 expected rate of return

• How does business count the cost?

interest costs

• How does business determine the amount of investment they undertake?

compare expected rate of return to interest cost . If expected return> interest cost, then invest
if expected return< interest cost, then do not invest

Aggregate Supply

Aggregate Supply- the level of Real GDP that firms will produce at 
each price level .

Long Run v. Short Run

• Long Run: period of time where input prices are completely flexible and adjust to change in price level. The level of Real GDP supplied is independent of price-level.
• Short Run: period of time where input prices are sticky and do not adjust to changes in price-level. The level of Real GDP supplied is directly related to the price level.

Long Run Aggregate Supply (LRAS)

• The LRAS marks the level of full employment in the economy (analogous to PPC).
• Because the  input prices are completely flexible in LR, changes in price-level do not change firms real profits and therefore do not change firms level of output. This means that LRAS is vertical at the economy's level of full employment

Changes in SRAS

• An increase in SRAS shift to the right
• A decrease in SRAS shift to the left
• The key to understanding shifts in SRAS is per unit cost of production
• *per unit cost = total input cost / total amount produced

Input Prices

• Domestic Resource Prices: wages (75% of all business costs), cost of capital, raw materials (commodity prices)
• Foreign Resource Prices: strong $ = lower foreign resource prices, weak $ = higher foreign resource prices
• Market Power
• Increase in Resource Power: increase = SRAS shift left; decrease = SRAS shift right

Productivity

• = total output / total input
• more productivity = lower unit production cost, SRAS -->
• lower productivity = higher unit production cost, SRAS <--

Legal-Institutional Environment
-Taxes & Subsidies

• taxes ($ to gov't) on business increase per unit production cost, SRAS <--
• Subsidies ($ from gov't) to business reduce per unit production cost, SRAS -->

-Government Regulation

• government regulation creates a cost of compliance, SRAS <--
• deregulation reduces compliance costs, SRAS -->

Aggregate Demand Curve

Aggregate Demand Curve                      
 AD is the demand by consumers, businesses for final goods and services.
AD = C + I + G + Xn

Why is AD downward sloping

Real Balance Effect

•  higher price levels reduce purchasing power of money
• decreases quantity of expenditures
• lower price levels increase purchasing power and expenditures

     Interest Rate Effect

• when price levels increases, lenders need to charge higher interest rates to get a real return loans
• higher interest rates discourage consumer spending and business investment

     Foreign Trade Effect

• when U.S. price levels rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods
• exports fall and imports rise causing real GDP demanding to fall ( Xn decrease)

Shifters of Aggregate Demand 
GDP = C + I + G + Xn

• There are 2 parts to a shift in AD: A change in C, Ig, G, and Xn; a multiplier effect that produces a greater change than the original change in the 4 components.
• Increases in AD = AD -->
• Decreases in AD = AD <--

Determinants of AD : C , G ,Ig, Xn

Consumption: household spending is affected by :
- consumer wealth ( more wealth= more spending, AD shifts right) (less wealth= less spending, AD shifts left)

-consumer expectations ( positive expectations= more spending, AD shifts right) ( negative expectations= less spending, AD shifts left)

-household in debt ( less debt= more spending, AD shifts right) ( more debt= less spending, AD shifts left)

-taxes (less tax= more spending, AD shifts right) ( more tax = less spending, AD shifts left)

Gross Private Domestic Investment: investment spending is sensitive to:
-Real interest rate (lower RIR= more investment, AD shifts right) ( higher RIR= less investment, AD shifts left)

-Expected returns (higher expected returns= more investment, AD shifts right) ( lower expected returns= less investment, AD shifts left)

Expected returns influenced by:

1. -expectations of future profitability
2. -technology
3. -degree of excess capacity (existing stock of capital)
4. -business taxes

Government Spending
-more government spending (AD shifts right)
-less government spending (AD shifts left)

Net Exports: are sensitive to:
-exchange rates (international value of dollar) (strong $= more imports & fewer exports, AD shifts left) (weak $= fewer imports & more exports, AD shifts right)

-relative income (strong foreign economies= more exports, AD shifts right) ( weak foreign economies= less exports, AD shifts left)