Fiscal Policy and the Multiplier Model
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Table of Contents
This section covers the following topics:
- Overview of fiscal policy
- Classical, Keynesian and supply-side viewpoints
- Deficits and debt
- The multiplier model
- Aggregate production
- Aggregate expenditures
- The effects of fiscal policy
Section Summary
The government can influence the economy through fiscal policy, which involves changing government spending and tax rates to increase or decrease GDP and GDP growth. Expansionary fiscal policy lowers tax rates and increases spending, stimulating economic growth. Contractionary fiscal policy does the opposite.
Classical economists recommend leaving the economy alone. Keynesian economists suggest using expansionary fiscal policy during a recession to prop up demand. Supply-side economists are in favor of cutting taxes to provide a greater incentive to earn income or invest.
The government budget deficit is the annual expenditures that are not paid for by annual income. The national debt is built up by each year’s budget deficit. The structural deficit will remain regardless of the business cycle, while the passive deficit only exists because the economy is in a recession. According to the Recardian equivalence theory, the national debt isn’t a problem since people will save more today in anticipation of higher taxes tomorrow. Since no one actually does this, the adverse effects of debt include higher future tax rates, crowding out of private investment and ever-increasing debt payments.
The multiplier model is designed to show the feedback effects in the macro economy. It has two components: the aggregate production curve and the aggregate expenditures curve (which includes both autonomous and induced expenditures). The economy is at equilibrium where the two lines intersect. If the economy is not at equilibrium, firms will increase or decrease production because they will have shortages or surpluses of goods. This adjustment continues until equilibrium is reached.
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