[ UNIT III ] Fiscal Policy [involves the taxing and spending policies of Congress] Automatic Fiscal Policy: (often called automatic fiscal policy stabilizers) These are policies/laws that are on the books and are activated automatically by circumstances in the economy in a counter-cyclical way to stabilize the economy. These function to “tame the business cycle.” [examples include]: the progressive income tax system ▪ most all transfer payments – but specifically social security and unemployment insurance Discretionary Fiscal Policy: requires new legislation on the part of Congress in response to specific economic conditions ▪ characterized by an insufferable long internal lag but a virtually nonexistent external lag ▪ can ONLY ever effect AD directly EXPANSIONARY Increase Government Expenditures Decrease Income Taxes Decrease Corporate Taxes CONTRACTIONARY (G) Decrease Government Expenditures (Tincome) Increase Income Taxes (Tcorporate) Increase Corporate Taxes (G) (Tincome) (Tcorporate) Aggregate Demand / Aggregate Supply (AD/AS) Analysis AD/AS graphs can illustrate three conditions in an economy that correspond roughly with a, b, c on PPC: not fully employing all factors of production at the highest level of technology – inefficient fully employing all factors of production at the highest level of technology – efficient desirable but not possible given current levels of factors of production and technology, alone [problem of]: high unemployment low output recession [long-run equilibrium]: full employment (FE) potential output (Y*) natural rate of UE (NAIRU) 0% cyclical UE not sustainable given current levels of factors of production and technology overheating INFLATION PROBLEM Graph A Y1 < FE Graph B Y* = FE 8 PROBLEM Graph C Y1 > FE Long-Run Aggregate Supply (LRAS) and PPC LRAS and PPC are the same thing and are both moved by the same things: 1. Changes in # of factors of production 2. Changes in $ of factors of production 3. Changes in technology      I      Tcorporate   AD      I    Tcorporate      DI     Tincome      C    DI  Tincome PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE) PL (P1-P2) rGDP (Y1-Y*) C AD UE (Y1-FE) PL (P1-P2) AD rGDP (Y1-Y*) UE (Y1-FE) AD   G  PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE) PL (P1-P2) rGDP (Y1-Y*) AD UE (Y1-FE) PL (P1-P2) rGDP (Y1-Y*) UE (Y1-FE)      AD   G AD = C + I + G + Nx … therefore, a decrease in one of these components will decrease AD. A decrease in AD is graphically expressed as a shift to the left with a corresponding decrease in price level (P1 – P2), decrease in rGDP (Y1 – Y * ), and increase in UE (Y1 –FE ). letter chains for Contractionary Discretionary Fiscal Policy Solution (implemented to address inflation)  AD = C + I + G + Nx … therefore, an increase in one of these components will increase AD. An increase in AD is graphically expressed as a shift to the right with a corresponding increase in price level (P1 – P2), increase in rGDP (Y1 – Y* ), and decrease in UE (Y1 –FE ). letter chains for Expansionary Discretionary Fiscal Policy Solution (implemented to address low output/high unemployment) TION GRAPH C FISCAL POLICY UTION GRAPH AFISCAL POLICY    growth: graphically expressed by shifting LRAS or PPC to the right EVERYTHING IN THIS CLASS IS SUBORDINATE IN IMPORTANCE TO GROWTH!!! “Story of I” is the Story of Growth: I buys K; increase I » increase K » increase AS » increase stock of K » LRAS (positive economic growth) [Negative growth is the same sequence of events with decrease instead of increase.] [multipliers related to taxing and spending]: basic concept – spending (consumption) becomes somebody else’s income, which is in turn split between further consumption and saving Disposable Income (DI) is split between consumption and spending. The fraction of the next bit of income that is spent is called MPC, whereas the fraction of the next bit of income that is saved is called MPS G bigger ▪ G is a direct component of AD Larger mps= smaller spending; smaller mps= larger spending T smaller because it affects DI and loses some of its initial effect to savings (leakage to savings)