Fiscal Policy

Classical or real-wage unemployment occurs when real wages are above competitive levels. This usually happens when labor unions ask for higher wages while the demand and supply of labor remain unchanged. On the contrary, Keynesian or cyclical unemployment is caused by insufficient or low aggregate demand. This is typical during recession when high or fixed rate of real wages do not fall to the competitive levels. Government policy can also cause the high fixed wage rates. b.

What are the marginal propensity to consume (MPC) and marginal propensity to save (MPS)? How are the two concepts related? How are the two concepts related to the consumption and saving functions? Marginal propensity to consume refers to the rate of change in consumption for every dollar increase in disposable income. Meanwhile, marginal propensity to save is the rate of change in savings for every dollar increase in disposable income. The relationship between MPC and MPS is like a mirror image because additional income is either consumed or saved. c.

Explain why proponents of supply-side effects of tax rate variations who also believe that tax-rate changes influence aggregate demand might claim that cuts in marginal income tax rates can potentially push up real Gross Domestic Product (GDP) without generating inflation We recall that the tax multiplier is the change in aggregate demand as a result of initial changes in taxes. Supply side economic policy can also stimulate demand through the Keynesian multiplier effect. A tax cut affects equilibrium real GDP in two ways. Firstly, it increases disposable income and thus increases consumer spending.

Secondly, it increases the size of the multiplier effect in the economy and thus increases real GDP. d. Explain how indirect crowding out can offset expansionary fiscal policy. An expansionary fiscal policy either cuts taxes, increases government spending or both, in order to boost a country’s total output. This type of fiscal policy also raises disposable income and interest rates. However, the rise in interest rates and the eventual appreciation of the currency can “crowd out” investments, hence offset the effects of the expansionary fiscal policy.

Meanwhile, crowding out reverses in a contractionary fiscal policy. When the government runs on a surplus, it buys back bonds; interest rates fall and thus stimulate investment. 2. Describe the situations and conditions that would surround a recession. What would appropriate discretionary fiscal policy be to remove these recessionary pressures? What are four potential problems of implementing these types of policy levers? A recession happens when there is a continued slowdown in real GDP for about 6 months to a year.

The slump must also be evident in most sectors of the economy. To eliminate a recessionary gap, an expansionary fiscal policy is appropriate. Some challenges in implementing this policy includes offsetting effects or crowding out, data mining, estimating potential income level, changing of government taxes and spending, size of debt, and conflicting national goals. 3. Describe the situations that would surround an inflationary period. What would appropriate discretionary fiscal policy be to remove these pressures?

What three automatic stabilizers would kick in to offset some of these inflationary pressures? Inflation occurs when real GDP raises above the full employment real GDP and results to rising level of prices. A contractionary fiscal policy may be applied to combat inflation. This means increasing tax rates or minimizing government expenditures. Automatic stabilizers such as social security, unemployment insurance and transfer payments may also be used to ward off inflationary pressures. 4. Describe the implication expansionary fiscal policy may have for a deficit budget.

How could this deficit be financed? Describe the implication of a surplus budget and what the government should do with it. As a country pumps prime its economy through increased public spending, it is inevitable that the country’s budget also leads to a greater deficit. To finance this deficit, the government can borrow money from its citizens by issuing government securities such as bills, notes and bonds. On the other hand in case of a budget surplus, the excess fund may be used to pay some of the country’s debt because these nation