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Effects of Fiscal Policy

Research Paper (undergraduate) 2010 26 Pages

Business economics - Economic Policy

Excerpt

Table of Contents

Executive Summary

List of Abbreviations

List of Figures

1. Introduction
1.1 Problem Definition
1.2 Objectives
1.3 Methodology

2. Effects of Fiscal Policy
2.1 Theory of Fiscal Policy
2.1.1 Economic Fluctuations in the Short Run
2.1.2 Influence of Fiscal Policy on Aggregate Demand
2.1.2.1 Multiplier Effect
2.1.2.2 Crowding-Out Effect
2.2 Fiscal Policy actions at the example of U.S
2.3 Effectiveness of Fiscal Policy

3. Results and Conclusion

Appendices

Bibliography

List of Abbreviations

illustration not visible in this excerpt

List of Figures

Fig. 1: Long-Run Equilibrium

Fig. 2: A contraction in Aggregate Demand

Fig. 3: The Multiplier Effect

Fig. 4: The Crowding-Out Effect

Fig. 5: Stimulus Packages as a Percent of GDP (2008-2010)

1. Introduction

The major economies have fallen into recession because of the current financial crises. The market is not able to regulate this crisis.

What can be done by the governments to avoid a further economic downturn? This assignment try’s to present an answer to this question.

1.1 Problem Definition

Governments can use monetary and fiscal policy to influence the economy. To act to the results of the financial crisis governments are using fiscal policy to avoid a further economic downturn.

1.2 Objectives

This paper is focused on presenting the theory of fiscal policy. Further an example is given to show how fiscal policy is applied. Finally the usefulness of fiscal policy is discussed.

1.3 Methodology

In the assignment a multi step approach will be used to present the objectives of chapter 1.2.

In the first part the theory of fiscal policy is introduced. It will be explained how fiscal policy effects the economy and what are the effects of fiscal policy.

In the second part on the example of U.S. it will be explained how fiscal policy was applied after the financial crises.

In the last part the advantages and disadvantages of fiscal policy are presented. It will be also discussed if the governmental use of fiscal policy is an appropriate strategy in the current situation.

2. Effects of Fiscal Policy

2.1 Theory of Fiscal Policy

To understand the theory of fiscal policy it is necessary to understand the theory of aggregate demand and aggregate supply. In the following chapters the theory of aggregate demand and supply will be just briefly described.

The theory part is limited to the needed knowledge to understand fiscal policy. Therefore the effects of a shift in the aggregate demand curve are described to understand what can be achieved with fiscal policy. Further the two effects that cause the result of governmental spending to differ from the total amount of governmental purchases are introduced.

2.1.1 Economic Fluctuations in the Short Run

The economic theory of short-run fluctuations was developed after the Great Depression of the 1930s by John Maynard Keynes. In the economic theory, short-run fluctuations are measured by the behaviour of two variables, the entire economic output of goods and services, also called the GDP, and the overall price level.

The aggregate demand informs about the quantity of all goods and services demanded in an economy at any price level. This can be expressed by the GDP (Y) which is the sum of consumption (C), investment (I), government purchases (G) and net exports (Nx):

illustration not visible in this excerpt

The aggregate supply reflects the quantity of goods and services that companies produce and sell at each level.

With the basic model of aggregate demand and aggregate supply the two causes of short run fluctuation can be examined.

To keep the examination simple it is assumed that the economy begins in long run equilibrium, like illustrated in Figure 1, point A. This point is where the aggregate demand curve crosses the long-run supply curve. If this point is reached wages, prices and perceptions are adjusted so that also the short run aggregate supply curve crosses this point as well (Mankiw, N.G. and Taylor M.P. (2008), p. 700).

Fig. 1: Long-Run Equilibrium

illustration not visible in this excerpt

Source: Mankiw, N.G. and Taylor M.P. (2003), p. 721

Because of an unpredictable event which affects the economy (e.g. wave of pessimism, crash in stock market, government scandal, war) households and firms lose confidence in future and cut back their spending and originally planed major purchases. This will cause a fall in aggregate demand (AD). Like illustrated in figure 2 the aggregate demand curve would shift to the left AD1 to AD2. The economy therefore moves from point A to point B. Further the output falls from Y1 to Y2 and the price level falls from P1 to P2. The lower output level indicates that the economy is in recession. Not shown in the picture is that company respond to the lower price by lay off their workforce (Mankiw, N.G. and Taylor M.P. (2008), p. 701).

Fig. 2: A contraction in Aggregate Demand

illustration not visible in this excerpt

Source: Mankiw, N.G. and Taylor M.P. (2003), p. 722

If the policymakers face such a situation, they can try to increase aggregate demand. If the policymakers act in the right time and the right precision they can offset the initial shift in aggregate demand and turn the aggregate demand to it’s originally level.

Even without actions, over the time the wages, prices and perceptions would adjust again. Like shown in figure 2 the short run aggregate supply ASi would shift to AS2 and the economy would reach point C. At this point the new aggregate demand curve crosses the long-run aggregate supply curve with the new price level P3 and the same output Y1.

It can be summed up, that in the short run shifts in the aggregate demand causing fluctuations in the economy output. But in the long run only the overall price level is affected but not the output (Mankiw, N.G. and Taylor M.P. (2008), p. 700-702 and Samuelson, Paul A. et al. (2005), p. 474-475).

2.1.2 Influence of Fiscal Policy on Aggregate Demand

When the government uses fiscal policy, governmental spending is increased to shift the aggregate demand curve directly. There are two effects that cause the result of governmental spending to differ from the total amount of governmental purchases. In the following chapters this two effects are described.

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Details

Pages
26
Year
2010
ISBN (eBook)
9783640580576
ISBN (Book)
9783656438960
File size
508 KB
Language
English
Catalog Number
v147267
Institution / College
University of applied sciences, Munich
Grade
1,3
Tags
Fiscal Policy Multiplier Effect Crowding-Out Effect general economics example Assignment Europe US
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Title: Effects of Fiscal Policy