Macroeconomics Study Guide 8-9
Fiscal polices—changes in government spending, taxes, and transfers—act as
aggregate demand shocks, have multiplied impact on real GDP, and can counter
output gaps. “Yes” and “No” camps favor different combinations of fiscal policies
Fiscal policy—changes in government purchases, taxes and transfers, to achieve
macroeconomic outcomes of steady growth, full employment, and stable prices.
Circular flow transmits effects of fiscal policy.
Injection—spending in circular flow that does not start with consumers: G
(government spending), I (business investment spending), X (exports)
Leakage—spending that leaks out of circular flow through taxes, savings, and
Multiplier effect—spending injection has multiplied impact on real GDP.
Multiplied impact increases real GDP from
-Increased government spending
-Increase in transfers
Multiplied impact decreasing real GDP from
-Decreased government spending
-Decrease in transfers
Size of multiplier effects depends on leakers out of circular flow.
-Multiplier effect for tax and transfers changes not as big as for government
-More leakages = smaller multiplier
-Fewer leakers = larger multiplier Any change in injections—G, I, X—affects aggregate demand and has multiplied
impact on GDP.
Fiscal policies to
-Increase government spending; cut taxes, increase transfers are positive aggregate
demand shocks to counter recessionary gaps.
-Decrease government spending; cut taxes, decrease transfers are negative demand
shocks to counter inflationary gaps.
“Yes” camp favors tax cuts instead of government spending to accelerate economy;
spending reductions instead of tax increases to slow down economy.
“No” camp favors government spending instead of tax cuts to accelerate economy;
tax increases instead of government spending reductions to slow down economy.
Fiscal Policies targeting aggregate supply—tax incentives, support for R & D,
educations, training—promote economic growth. Yes and No camps both support
government supply-side fiscal polices, but differ in emphasis on long-run (Yes) or
short-run (No) effects.
Tax-incentives can stimulate savings, increase quantity of capital, and promote
Positive (or negative) externalities—benefits (or costs) that affect others external
to a choice or a trade
Government spending and tax incentives for
-Research and development activities: create positive externalities promoting
-Education and training that increase human capital: created positive externalities
promoting economic growth
Fiscal spending and tax policies can increase quantity and quality of inputs,
increasing aggregate supply and potential GDP per person.
Supply-side effects—the incentive effects of taxes on aggregate supply.
Supply siders—believe tax cuts have powerful incentive effects and will increase,
not decrease, government tax revenues -Evidence shows that beliefs are false. Tax cuts reduce revenue.
-Supply-sider augments appeal to politicians who promise tax cuts—which voters
like—without having to reduce government services or go into debt.
-Economists often refer to supply-sider arguments as “voodoo economics”
Because of externalities, Yes and No camps both supply government supply-side
fiscal policies to promote growth.
Fiscal policies that encourage savings, capital investment, and future economic
growth can also decrease aggregate demand in the present.
“Yes” camp believes long-run benefits of increased aggregate supply outweigh
short-run mismatches between reduced aggregate demand and aggregate supply.
“No” camp concerned that short-run decreases in aggregate demand cause
recession; costs of slowly adjusting markets outweigh long-run benefits of economic
Automatic stabilizers create cyclical budget deficits and surpluses while keeping the
economy close to potential GDP. Structural deficits and surpluses at potential GDP are
Government budget scenarios:
Balanced budget- Revenues = spending
Budget deficit- Revenues < spending
Budget surpluses- Revenues > spending
Automatic stabilizers—tax and transfer adjustments that counteract changes to
real GDP without explicit government decisions
-During contractions, tax revenues fall and transfer payments increase, supporting
spending and aggregate demand, but causing automatic budget deficit.
-During expansions, tax revenues rise and transfer payments decrease, reducing
spending and aggregate demand, but causing automatic budget surplus.
Automatic stabilizers work like thermostat, keeping economy close to potential GDP
regardless of shocks to aggregate demand or supply.
-Since automatic stabilizers were introduces after the Great Depression, business
cycles in Canada have been less frequent, contractions less severe. Cyclical deficits and surpluses—created only as result of automatic stabilizers
counteracting business cycles.
With automatic stabilizers, government attempts to balance the budget during:
-Recessions decrease aggregate demand makes recessions worse
-Expansions increase aggregate demand increase risk of inflation
With a balanced budget over the business cycles, cyclical surpluses during
expansions offset cyclical deficits during contractions
Economistic most concerned with structural deficits and surpluses—budget
deficits and surpluses occurring at potential GDP
Deficits are a flow while debt is a stock. Of five common arguments about national
debt, some are myths, some potential problems.
Deficits and debt have different time dimensions
-Deficits and surpluses are flows—amounts per unit of time—usually measured per
-Debt is a stock—fixed amount at moment in time
National debt (public debt)—total amount owed by government = (sum of past
deficits) – (sum of past surpluses)
-Canada’s national debt in 2009 was 463.7 billion.
-Canada’s 2009 ration of national debt to GDP was about 28%, compared to U.S.
58%, UK 62%, and Germany 70%
Five common arguments about weather national debt is a problem, or reflects wise
government use of fiscal policy to correct post problems of business cycles are.
1) Will Canada go bankrupt?
-Largely a myth
-Government of Canada never has to pay back national debt—can simply
refinance it. -Governments that do not pay debts find it difficult and expensive to borrow
on international bond market.
2) Burden for future generations
-Depends on who receives interest payments on national debt—Canadians or
-Canadians currently receive 80% of interest on national debt, so interest
payments more redistributed of money than burden
3) Debt is always bad.
-Myth—consumers with mortgages, car leases, and businesses issuing bonds
to build factories, make smart choices to go into debt.
-Government debt can be smart choice if positive impact on economy of
spending financed by debt is greater than interest cost.
-Government debt can be not-smart choice if spending finances by debt for
-Yes camps opposes, No camp supports, debt-financed government spending
to prevent recession
4) Interest payments create self-perpetuating debt.
-Potential problem of nat