Topic 5: Fiscal Policy and AS-AD Model - Knowledge Summary and Exam Analysis

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Department
Economics for Management Studies
Course
MGEA06H3
Professor
Iris Au
Semester
Winter

Description
Knowledge Summary: Topic 5: Part A – Fiscal Policy as an Automatic Stabilizer Full-Employment Level of Output and Output Gaps • Full-employment level of output =>FE • The term “full employment” means: o “Good” workers find it “easy” to find a job o “Young” workers find it “easy” to find their first job o “Old” workers are not forced out of the labour force if they lose their jobs (i.e., no discouraged workers) • The unemployment rate at YFE is called the non-accelerating inflation rate of unemployment (NAIRU) or natural rate of unemployment (NRU) • Full employment does not mean everyone is working because o Frictional employment o Structural employment o Labour market is dynamic o “frictions” in the economy (some industries expand while others contract) Recessionary or Deflationary Gap • It occurs when equilibrium level of output (Y*) is less than the full-employment levFE (Y* < Y ) • This means that the economy is producing less output than is normally associated with full employment • Since output demand is less, firms lay off workers => leads to recessionary or deflationary gap (pressure for price to drop) Inflationary Gap • It occurs when equilibrium level of output (Y*) is greater than the full-employment levFE (Y* > Y ) • This means that the economy is producing more output than is normally associated with full employment • Since output demand is more, firms hire more workers or ask them to work overtime => leads to inflationary gap (pressure for price to increase) Endogenous Budget Balance & Output Gaps • Recall, BB = T – TR – G o If BB < 0, the government runs a budget deficit o If BB > 0, the government runs a budget surplus • Whenever the government runs a budget deficit, it needs to finance its deficit by borrowing or issuing government bonds • When a government runs persistent budget deficit, the stock of national debt increases as the government needs to borrow from the public (This is bad) • If the government runs a deficit when Y = Y ,FEhen we have a structural deficit • If there is no deficit or surplus atFE , but the government runs occasional deficit when Y < Y ,FE then we have a cyclical deficit Relationship between Output Gaps and Budget Balances • Assumption for MGEA06: No structural deficit (BB = 0 when Y = Y FE • When there is a gap between initial output and full-employment output, the government can adjust its budget (fiscal policy) to bring Y back tFEY • In the case of a deflationary/recessionary gap (Y*
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