Unit 3: Automatic or Built-In Satabilizers

Automatic or Built-In Stabilizers

• Anything that increases the government’s budget deficit during a recession and increases its budget  surplus during inflation WITHOUT REQUIRING EXPLICIT ACTION BY POLICY MAKERS
• Economic Importance:
• Taxes reduce spending and aggregate demand
• Reductions in spending are desirable when the economy is moving toward inflation
• Increases in spending are desirable when the economy is heading toward recession.

• Progressive Tax System
• Average tax rate (tax revenue/GDP) rises with GDP
• Proportional Tax System
• Average tax rate remains constant as GDP changes
• Regressive Tax System
• Average tax rate falls with GDP
• The more progressive the tax system, the greater the economy’s built-in stability.

Unit 3: Fiscal Policy

Fiscal Policy

Definition: Changes in the expenditures or tax revenues of the federal government.

• 2 tools of Fiscal Policy:
• Taxes - government can increase order or decrease taxes
• Spending - Government can increase or decrease spending
• Inverse relationship

Deficits, Surpluses, and Debt

• Balanced Budget
• Revenues = Expenditures
• Budget Deficit
• Revenues < Expenditures
• Budget Surplus
• Revenues > Expenditures
• Government Debt
• Sum of all deficits - Sum of all Surpluses
• Government must borrow money when it runs a budget deficit. They borrow from:
• Individuals
• Corporations
• Financial Institutions
• Foreign Entities or Foreign Governments

Fiscal Policy (Two Options)

• Discretionary Fiscal Policy (action)
• Expansionary fiscal policy - think deficit
• Contractionary fiscal policy - think surplus
• Non - Discretionary Fiscal Policy (no action)

Discretionary vs. Automatic Fiscal Policies

• Discretionary
• Increasing or Decreasing Government Spending and/or Taxes in order to return the economy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem.
• Example: Recession and Inflation
• Automatic
• Unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Automatic fiscal policy takes place without policy makers having to respond to current economic problems.
• Example: Medicare and Medicaid

“Easy” Expansionary Fiscal Policy	“Tight” Contractionary Fiscal Policy
Combats Recession	Combats Inflation
Increases Government Spending Decreases Taxes	Decrease in Government Spending Increase in Taxes

Unit 3: Marginal Propensity to Consume (MPC)

Marginal Propensity to Consume (MPC)

Definition: The fraction of any change in disposable income that is consumed.

• MPC = Change in Consumption / Change in Disposable Income
• MPC = Change in Savings / Change in Disposable Income

Marginal Propensities

• MPC + MPS = 1
• .: MPC = 1 - MPC
• .: MPS = 1 - MPC
• Remember that people do two things with their disposable income, consume it or save it !

The Spending Multiplier Effect

Definition: An initial change in spending (C, IG, G, Xn) causes a larger change in any aggregate  Spending, or Aggregate Demand (AD).

• Multiplier = Change in AD / Change in Spending
• Multiplier = Change in AD / Change in C, I, G, or Xn

Calculating the Spending Multiplier

Definition: The Spending Multiplier can be calculated from the MPC or the MPS.

• Spending Multiplier = 1 / 1 - MPC or 1 / MPS
• Spending Multipliers are (+) when there is an increase spending and (-) when there is a decrease in spending.

Calculating the Tax Multiplier

Definition: When the government taxes, the multiplier works increase

• Why?
• Because now $ is leaving the circular flow.
• Tax Multiplier ( note: it’s negative)
• Tax Multiplier = -MPC / 1 - MPC or -MPC / MPS
• If there is a tax -CUT, then the multiplier is (+), because there is now more $ in the circular flow.

Unit 3: Disposable Income (DI) - APS &APC

Disposable Income (DI)

Definition: Income after taxes or net income.

Formula: DI = Gross Income - Taxes

Two Choices

With disposable income, households can either :

• Consume (spend $ on goods and services)
• Save (not spend $ on goods and services)

1. Consumption

• Household Spending
• The ability to consume is constrained by:
• The amount of disposable income
• The propensity to consume
• Do households consume if DI =0?
• No

APC and APS

• APC + APS = 1
• 1 - APC = APS
• 1 -  APS = APC
• APC > 1 .: (period of dissaving)
• -APS .: (period of dissaving)

Unit 3: Interest Rates and Investment Demand

Interest Rates and  Investment Demand

What is Investment?

Definition: Money spent or expenditures on:

• New plants (factories)
• Capital equipment (machinery)
• Technology (hardware & software)
• Inventories(goods sold by producers)

Expected Rates of Return

1. How does business make investment decisions?
1. Cost/ benefit analysis
2. How does business determine the benefits?
1. Expected rate of return
3. How does business count the cost?
1. Interest costs
4. How does business determine the amount of investment they undertake?
1. Compare expected rate of return to interest cost
• If expected return > interest cost, then invest
• If expected return < interest cost, then do not invest

Real (r%) vs. Nominal (i%)

What’s the difference?

Definition: Nominal is the observable rate of interest. Real subtracts out inflation (π%) and is only known ex post facto.

1. How do you compute the real interest rate (r%)?
1. Formula: r% = i% - pi%
2. What then, determines the cost of an investment decision?
1. The real interest rate (r%)

Investment Demand Curve (ID)

1. What is the shape of the Investment demand curve?
1. Downward sloping
2. Why?
1. When interest rates are high , fewer investments are profitable, when interest rates are low, more investments are profitable.

Shifts in Investment Demand (ID)

• Cost of Production
• Lower costs shifts ID right
• Higher costs shifts ID left
• Business Taxes
• Lower business taxes shifts ID right
• Higher business taxes shifts ID left
• Technological Change
• New technology shifts ID right
• Lack of technological change shifts ID left
• Stock of Capital
• If any economy is low on capital, then ID shifts right
• If any economy has much capital, then ID shifts left
• Expectations
• Positive expectations shift ID right
• Negative expectations shifts ID left