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Lecture 6

ECO1102 Lecture 6: Week 7_ March 2&7

4 pages38 viewsSpring 2018

Department
Economics
Course Code
ECO 1102
Professor
David Gray
Lecture
6

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March 7
Fiscal policy
Should fiscal policy be used to stabilize the economy?
Should govt wait for the economy to correct itself or should it use fiscal policy to
stabilize the economy?
Problem 1: Fiscal policies are often educated guesses
Problem 2: Time lags between the “problems”
Are identified
Information lag: understanding the current economy
When policies are chosen
Analysis lag: deciding on the appropriate policy
When policies are implemented
Formulation lag: passing the required legislation
When policies take effect
Implementation lag: affecting the economy
Often cause fiscal policy to be ineffective or even harmful
Automatic stabilizers
Automatic stabilizers are changes in taxes or govts spending that offset economic
fluctuations without policymakers having to take deliberate action
Stimulate AD when the economy contracts
Dampen AD when the economy expands
Examples:
Taxes fall automatically in recessions as incomes falls, which prevents AD from
contracting as much
The progressive nature of income taxes means that higher tax rates apply as
earnings rise, which puts a check in overall spending and AD
In recessions, more people apply for public assistance so that govt spending
Discretionary fiscal policy
Policy-makers can also use discretionary fiscal policy to respond to economic conditions
Information, analysis, formulation and implementation lags can reduce the
effectiveness of such policy
Discretionary policy may be used when automatic stabilizers are unsuccessful in
correcting the economy
Eg: Politicians may cut taxes in response to recessions
But tax cuts are not “free” because govt must find a way to make up for the lost
tax revenue
Ricardian equivalence predicts that people will not change their behaviour (AD will not
increase) if there are tax cuts but no decrease in spending
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