Chapter 7

Fiscal Policy

These slides supplement the

textbook, but should not
replace reading the textbook
1
 Who were the
Classical Economists?
A group of the 18th and 19th
centuries, including Adam
Smith known as the father
of modern day economics
2
 What did Adam Smith
and the Classical
Economists believe?
The economy was always
tending toward a full
employment equilibrium
and stable prices
3
 What does
laissez-faire mean?
Leave well enough alone,
let the economy correct
problems itself

4
What happened in the
Depression of 1921?
Even though it was
serious the
government practiced
laissez-faire and the
economy recovered in
a short period of time
5
 What were policies of
President Herbert Hoover
in the early 1930s to
combat the depression?
 public works projects
 raised taxes
 loans to failing firms
 relief programs
6
 What were policies of
President Franklin
Roosevelt in 1933 to
combat the depression?
 public works projects and
social welfare programs
 raised taxes and wages
 loans to failing firms
 relief programs 7
According to Robert Reich,
an American political
economist and professor,
what was the result of these
government programs?
These programs helped
save American capitalism

8
According to Thomas Woods
author of Meltdown, what
was the result of these
government programs?
These programs prevented the
economy from seeking its
equilibrium of full employment
and prolonged the depression
9
 What is a
fiscal policy?
The manipulation of
government purchases,
transfer payments,
taxes, and borrowing in
order to positively
influence the economy
10
 How did Keynes
influence fiscal policies?
He argued that fiscal
policies may be
necessary to bring
about full employment
11
How did World War II
affect fiscal policies?
It showed that a
government stimulus
package can work

12
 What is the
Employment Act of 1946?
Its main purpose was to
lay the responsibility of
economic stability of
inflation and
unemployment onto the
federal government
13
What are the four
phases of the
business cycle?
• trough
• recovery
• peak
• recession
14
 What are the 3 pillars
of
Keynesian Economics?
• Liquidity trap
• Balanced budget multiplier
• Paradox of thrift
15
 What is a
liquidity trap?
A lack of borrowing keeps
money bottled up in
savings institutions

16
 What is the
Keynesian solution to
a liquidity trap?
Government borrows the
money that consumers and
business do not borrow
17
 What is the
Balanced Budget
Multiplier?
When the government taxes
and spends the money
there is a multiple effect
because of no savings
18
 What is the
Paradox of Thrift?
The more people save, the
less will be demand, which
leads to slow growth

19
 What does crowding
out mean?
During periods of full
employment the
government can borrow
money that otherwise
would be spent or invested
20
 How does the
government borrow
money?
It sells bonds
(securities) to the Fed
or in the Open Market

21
 What is the current
national debt?
Just over $17.5 trillion
http://www.usdebtclock.org/

22
What does monetizing
the debt mean?
The federal government
sells bonds (securities)
to the Fed and the Fed
creates the money to
buy the bonds
23
 What can monetizing
the debt lead to?
A fall in the value of the
dollar and inflation

24
 What is a
discretionary fiscal
policy?
Government policies that
require ongoing decisions
by policy makers

25
What are some examples
of fiscal policies?
 Government purchases
 Transfer payments
 Taxes

26
 What are
automatic stabilizers?
Structural features of
government spending
and taxation smooth
out fluctuations in
booms and busts
27
 What are some
examples of
automatic stabilizers?
 Unemployment payments
 Welfare
 Other govt. programs
28
 What is the point of
Keynesian Economics?
The economy could be
stuck at equilibrium below
the potential output for a
prolonged period of time
29
 What is an expansionary
fiscal policy?
An increase in government
purchases, decrease in net
taxes, or some combination of
the two aimed at increasing
aggregate demand
30
 When would the
government use
expansionary fiscal
policies?
To stimulate the economy
when unemployment is
greater than the natural rate
31
What is a contractionary
fiscal policy?
A decrease in government
purchases, increase in net
taxes, or some combination
of the two aimed at reducing
aggregate demand
32
 When would the
government use
contractionary fiscal
policies?
To slow down the
economy when inflation is
more than desired
33
 What is the typical
Keynesian policy
during recessions?
To use discretionary fiscal
policies to stimulate the
economy to a full
employment equilibrium
34
What is the multiplier?
Any change in the level
of spending has a
multiple effect on GDP

35
What is the accelerator?
Any increase in spending
can lead to an increase
in secondary spending,
for example, a new
highway may lead to
more restaurants,
hotels, and gas stations
36
 When does the
accelerator have most
impact on spending?
During periods of
full employment

37
How did World War II
affect fiscal policies?
It showed that a
government stimulus
package can work

38
 What is MPC?
The marginal propensity
to consume (MPC) is a
measure of how much
consumers will spend
out of any addition to
their income
39
 What is MPS?
The marginal propensity to
save (MPS) is a measure
of how much consumers
will save out of any
addition to their income
40
 If MPC is ¾, what
is MPS?
MPS would be ¼ because
MPC + MPS = 1

41
What is the value of
the multiplier?
1 / MPS

42
If MPC is ¾, what is
the value of the
multiplier?
1/¼=4
43
$100.00
$75.00
$56.25
original spent
$42.19
$31.64 total money
...
$400.00
44
 What effect does an
increase in demand have
on prices and output?
The more steeply sloped
the supply curve the
greater impact on prices
and the less impact on
employment
45
Slightly sloped Supply Curve
Price
Level
SRAS

AD*
AD
Real GDP 46
Steeply sloped Supply Curve
Price
Level SRAS

AD*

AD
Real GDP 47
How effective are
fiscal policies?
Automatic stabilizers
are more effective
than are discretionary
fiscal policies

48
 Should we rely on
automatic stabilizers?
The stronger and more
effective the automatic
stabilizers are, the less
need there is for
discretionary fiscal policies
49
How effective were fiscal
policies during the
stagflation of the 1970’s?
Whatever we did to fight
one problem we made
the other problem worse
50
What are lag effects?
 Recognition lag
 Decision lag
 Action lag

51
 Do lag effects
influence discretionary
fiscal policies?
Yes, they weaken fiscal
policies as a tool of
economic stabilization
52
 What is one’s
permanent income?
Income that individuals
expect to receive on
average over the long term

53
 Do consumers base their
decisions on their
permanent income or their
short term income?
Perceived long term income

54
What is one thing policy
makers often overlook?
How fiscal policies
unintentionally affect
individual incentive to
work, save and invest
55
 What is the
Laffer Curve?
A curve that shows that
starting from zero an
increase in taxes will
raise revenue but beyond
a point an increase will
lower revenues 56
What is the Laffer Curve?

57
 What is
supply side economics?
The belief that real GDP
can be increased by
giving people
incentives to work
58
 What was fiscal policy in
the Reagan Administration
of the 1980’s?
Taxes were decreased
to stimulate the
economy by increasing
aggregate supply
59
What effect does politics
have on fiscal policies?
There is always the
danger that politicians
can use discretionary
fiscal policies to suit their
short term political goals
60
Does the federal deficit
affect fiscal policies?
If we were to increase
spending by borrowing,
the national debt could
become unmanageable
61
 Watch video on the
National Debt
http://video.search.yahoo.com/video/pl
ay?p=national+debt&n=21&ei=utf-8&js
=1&fr2=tab-web&tnr=20&vid=0001655
45891

62
What is the difference
between a stock and a
flow way of thinking?
An example of a stock
situation would be an
increase in government
spending has no
opportunity costs
63
 If we spend a dollar
do we pay for that
dollar here and now?
Yes, either by higher
taxes, higher interest
rates if we borrow the
money, or more inflation
if we create the money
64
END
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