MAcro CHAPTER 3.8:

CHAPTER SUMMARY

Fiscal policy is the way the government can affect the economy through taxation and spending. There are two types of fiscal policy:

• Expansionary fiscal policy: trying to grow the economy by either lowering taxes or raising spending.

• Contractionary fiscal policy: trying to slow down the economy by either raising taxes or lowering spending.

A lot of government taxation and spending is non-discretionary, meaning that it is permanent and not really meant to impact the economy itself. For example, the U.S. government always spends a lot of money on the military - this is not something they would decide to increase or decrease for economic reasons.

However, the government will also sometimes engage in discretionary fiscal policy, meaning they change the amount they tax or spend with the specific purpose of impacting the economy. One example of this is giving out stimulus checks to citizens in order to increase spending.

So if they want to influence the economy through fiscal policy, how do they know what to do? The first thing they need to know is the amount of the recessionary or inflationary gap. In the chart below, you can see that there is a $50 recessionary gap, as the LRAS is $200, but the short-run aggregate equilibrium is only $150.

The next thing they need to know is the marginal propensity to consume (MPC) and marginal propensity to save (MPS) in the economy. Let's imagine that the MPC is 0.8.

With this information, we can calculate our spending multiplier and our tax multiplier:

Spending multiplier = 1 / MPS = 1 / 0.2 = 5

Tax multiplier = -MPC / MPS = -0.8/0.2 = -4

This means that, any change in spending will have a multiplier effect of 5, and any change in taxation will have a multiplier effect of -4. So, if the government want to make up a gap of $50, they can use this information to figure out how much to increase spending or decrease tax.

Spending: $50 / 5 = $10

Taxation: $50 / -4 = -$12.50

By dividing the amount of change needed in Real GDP by the multipliers, we can figure out that the government could either spend $10 or reduce taxation by $12.50 in order to close the recessionary gap and bring the Real GDP back to long-run equilibrium.

If there were an inflationary gap, the government could do the exact opposite, either reducing spending or increasing taxation.

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