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ECON 1010
Sadia Mariam Malik

Chp.29 Fiscal Policy What are the effects of government spending and taxes on the economy? Does it create jobs or destroy them? So Fiscal Policy is Budgets of the government activity that achieve macroeconic policy objectives. The Budget balance formula is Budget Balance revenues – outlays. Budget Surplus: revenues > outlays. Budget deficit: revenues < outlays. Balanced budget: revenues = outlays. Revenues have 4 sources: Personal income tax, corporate tax, indirect, investment income. OutLays have 3 sources: Transfer payment, debt interest , goods and services. Government Debt (Total amount of government borrowing) = past deficits – past surplus What does the supply-side have on affect to the fiscal policy? Income tax changes full employment and potential GDP. Higher income taxes decrease incentives to work by creating the Tax Wedge. Tax Wedge: The gap b.w before –tax wage rate after tax-wage rate. What is the effect of an income tax in the labour market? The supply of labour decreases b/c the tax decreases the after-tax wage rate. In this case the after-tax rate falls while the before-tax rate increases. The quantity of labour employed decreases. Taxes on consumption increase the wedge by increasing consumption taxes, lowering rl wage rate and labour supply. This decreases the supply of loanable funds and investment and saving decrease. Taxes on interest income weaken incentives to save, reduce quantity of saving and therefore reduces investment and growth rate of rl GDP. Nominal interest rate(before adjustment for inflation) is taxed, the impact is on real after-tax interest rate. Laffer Curve: relationship b/w tax rate and tax revenues collected. If tax rate below t*, a rise in tax rate increases tax revenue. If tax rate above t*, a rise in tax rate decreases tax revenue. How do we stabilize the business cycle? Through Discretionary or automatic fiscal policy. Government Expenditure Multiplier: effect of government expenditures on aggregate demand. An increase in Government increases rl gdp. This leads to secondary induced effects. Autonomous tax multiplier: effect of autonomous taxes on aggregate demand. An increase in T(autonomous taxes) decreases YD (Disposable income), and decreases rl gdp which leads to secondary, induced effects. And vice versa. Balanced budget multiplier: effect of equal change in taxes and government expenditure. Positive. If rl gdp D.income, Dissaving. C.Expenditure < D.income, Saving. What is MPC? MPC stands for Marginal Propensity to Consume. It is the change in disposable income spent on consumption. MPC = What is MPS? MPS stands for Marginal Propensity to Save. It is the change in disposable income that is saved. . MPS = Therefore MPC+MPS = 1 ALWAYS. Imports are also influenced by rl gdp. Marginal Propensity to import = . Induced Expenditure = Consumption exp – imports. Actual agg exp is equal to rl gdp. But not always since firms usually end up with inventories that are greater or smaller than planned. Equilibrium Exp only occurs when Agg planned exp = Rl GDP. (Crosses 45 line on curve). Agg planned exp > Rl gdp (Above 45 , means unplanned decrease in inventories. To restore inventories, firms hire workers and increase production. Rl gdp Agg planned exp < Rl gdp (Below 45 , means there is an unplanned increase in inventories. To reduce inventories, firms fire workers. Rl gdp IF they equal each other, then everything is table and Rl gdp remains constant. What is the Multiplier? Is the change in expenditure multiplied to determine change in equilibrium exp and rl gdp. An increase in autonomous expenditure increases aggregate expenditure which also increases rl gdp. What is the size of the multiplier? Change in Equilibrium exp / Change in autonomous exp Multiplier >1 because of induced effects. Multiplier = 1 / (1 – Slope of AE). Which therefore states that Multiplier = 1 / MPS. The higher the induced effects, the larger the multiplier. Imports and income taxes reduce the size of the multiplier. The Business cycle turning points peaks and trough occur when autonomous exp changes. An in autonomous exp brings unplanned in inventories that trigger an expansion. An in autonomous exp brings an unplanned in inventories, this triggers a recession About the Aggregate Demand curve. It shows the relationship between rl gdp demanded and the price lvl(With other things remaining the same). An increase in price shifts AE curve (Because of wealth and substitution effects). IT also equilibrium rl gdp. Non price variables shift both AE and AD curves. In the short run, increase in AE leads shift in AD curve, price lvl, AE somewhat making the multiplier smaller. In the long run, vertical LAS(Long run aggregate supply) means there is large enough increase in p.lvl to cause a decrease in AE that increase, Multiplier = 0. Chp.26 Agg supply and Demand The purpose of the aggregate demand model is to explain how rl gdp and price lvl are determined and how they interact. AS-AD is Aggregate Supply Aggregate Demand. The quantity of rl gdp supplied depends on quantities of labour, physical and human capital, state of technology. Over the business cycle, employment fluctuates around full employment, as rl gdp fluctuates around potential employment. Two time frames distinguished in the labour market: Long-run agg supply and Short-run agg supply. Aggregate supply is the relationship between the quantity of rl gdp supplied and the price lvl. Long-run agg supply(LAS = Potential GDP) is always vertical. It is the relationship b/w the quantity of rl gdp supplied and the price lvl when money wages rate changes. The quantity of rl gdp = potential gdp. LAS shifts when potential gdp increases due to an increase in labour, capital stock, and technology advancements. The real wage rate remains constant at full employment. So what is the Short-run agg supply (SAS = RL GDP)? Relationship b/w rl gdp supplied and price lvl when the money wage rate, potential gdp, etc all remain constant. SAS is an slope. Money wage rate, prices of other resources, and potential gdp all remain constant. If rl gdp is potential gdp, then there is a shift . If rl gdp is potential gdp, then there is a shift . If production , marginal cost .Note that for production purposes, the firm produces the quantity that maximizes profit. If production , marginal cost What causes potential GDP to grow? Increase in Q of labour. Tech advances. Increase in full employment. Potential gdp increases b/c the labour force increases. But with constant capital and technology, PGDP only increases if full employment quantity of labour increases. Fluctuations are not changes in potential gdp and long run aggregate supply. If potential gdp increases, the line shifts. The greater the human capital, the higher the potential gdp. Money Wage Rate: the number of dollars that an hour of labour earns. What does a rise in money wage rate do? It shitfts the SAS curve . What makes money wage rate change?? Inflation Departures from full employment What is agg demand? It is the relationship b/w Q.of rl gdp demanded and P.lvl. It slopes for 2 reasons. Wealth effect and Substitution effect. Wealth effect: P.lvl , while other factors remain the same, wealth . In this case people should save and hold money at this state. Substitution effect: P.lvl , while other factors remain the same, wealth the interest rate. Note: when p.lvl , rl gdp demanded . What increases? Agg demand? Unemployment benefits and welfare payments. Disposable income = agg income – taxes + transfer payments. If exports > imports , agg demand increases. Agg demand . When f.income inflation, profit all increase . Agg demand . When f.income inflation, profit all increase . LAS equilibrium occurs when rl gdp = potential gdp when AD = SAS = LAS. SAS equilibrium occurs when AD = SAS with p adjusting For the SAS curve, when looking at the graph o
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