3.8 and 3.

9
Fiscal Policy and Automatic Stabilizers
 Crash Course worksheets are available at www.acdcecon.com.
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 The Role of Consumers in the Economy
Consumption is the most important part of the
economy.
Consumers will spend a certain amount no matter
what, regardless of their income. This is called
autonomous consumption.
This is usually to pay for necessities.
Consumer spending is made up of autonomous
spending and disposable income (income after taxes).
If incomes are less than autonomous spending, then
there is dissaving (or negative savings).
But what if incomes fall and people stop
buying things? Who often steps in?
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 How does the Government Stabilize the
Economy?
The Government has
two different tool
boxes it can use:
1. Fiscal Policy-
Actions by Congress to
stabilize the economy.
2. Monetary Policy-
Actions by the Federal
Reserve Bank to
stabilize the economy.

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 For now we will only focus on Fiscal Policy.

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 Fiscal Policy

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 Discretionary vs Non-Discretionary
Discretionary Fiscal Policy
• Congress creates a new bill that is designed to change
AD through government spending or taxation.
•One problem is lag times due to bureaucracy.
•It takes time for Congress to act.
•Example: In a recession, Congress increases spending.
Non-Discretionary Fiscal Policy
•AKA: Automatic Stabilizers
•Permanent spending or taxation laws enacted to work
counter cyclically to stabilize the economy.
•When GDP goes down, government spending
automatically increases and taxes automatically fall
•Examples: Welfare, Unemployment, Income Tax.
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 Contractionary Fiscal Policy (The BRAKE)
Laws that reduce inflation, decrease GDP (Close an
Inflationary Gap).
• Decrease Government Spending.
• Increase Taxes (Decreasing disposable income).
• Combinations of the Two.

Expansionary Fiscal Policy (The GAS)

Laws that reduce unemployment and increase GDP
(Close a Recessionary Gap).
• Increase Government Spending.
• Decrease Taxes (Increasing disposable income).
• Combinations of the Two.

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 Fiscal Policy Practice
Congress uses discretionary fiscal policy to the
manipulate the following economy. (MPC = .8)
Price
LRAS 1. What type of gap?
Level
AS 2. Contractionary or
Expansionary needed?
3. What are two options
to fix the gap?
P1 4. What is the least
amount of initial
government spending
AD2 AD1 to close gap?
$500 $1000FE $100 Billion
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Real GDP (billions) 9
 Fiscal Policy Practice
Congress uses discretionary fiscal policy to the
manipulate the following economy. (MPC = .5)
Price
LRAS 1. What type of gap?
Level
AS 2. Contractionary or
Expansionary needed?
P2 3. What are two options
to fix the gap?
4. How much needed to
close gap?
-$10 Billion
AD1 AD
$80FE $100
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Real GDP (billions)
 Cutting Tax Practice
Congress uses discretionary fiscal policy to the
manipulate the following economy. (MPC = .8)
Price
LRAS 1. What two options does
Level
AS the government have?
2. How much government
spending to close the
gap?
P1 $4 Billion
3. How much tax cut to
close the gap?
AD2 AD1 $5 Billion
$80 $100FE Tax Cut
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Real GDP (billions) 11
 Timing and Fiscal Policy
One of the problems of fiscal policy is that it
takes time to go into effect.
Fiscal policy often has three time lags:
1. Recognition Lag- Congress must react to
economic indicators before it’s too late.
2. Administrative Lag- Congress takes time to
pass legislation.
3. Operational Lag- Spending/planning takes
time to organize and execute (changing
taxing is quicker).

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 Topic 3.9-
Automatic Stabilizers
 Discretionary vs Non-Discretionary
Discretionary Fiscal Policy
• Congress creates a new bill that is designed to change
AD through government spending or taxation.
•One problem is lag times due to bureaucracy.
•It takes time for Congress to act.
•Example: In a recession, Congress increases spending.
Non-Discretionary Fiscal Policy
•AKA: Automatic Stabilizers
•Permanent spending or taxation laws enacted to work
counter cyclically to stabilize the economy.
•When GDP goes down, government spending
automatically increases and taxes automatically fall
•Examples: Welfare, Unemployment, Income Tax.
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 These are policies that work counter
cyclically to stabilize the economy
Real
Government spending
GDP
and transfers
automatically decrease Real GDP

Government spending
and transfers
automatically increase
Time

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 These are policies that work counter
cyclically to stabilize the economy
Real
Taxes
GDP
automatically
increase
Real GDP

Taxes
automatically
decrease
Time

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 US 2022 Income Tax Brackets

https://taxfoundation.org/2022-tax-brackets

Why does this tax system lessen the effects of a

recession and help stabilize the economy?
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 Non-Discretionary Fiscal Policy
The U.S. Progressive Income Tax System acts
counter cyclically to stabilize the economy.
1. When GDP is down, the tax burden on
consumers is low, promoting consumption and
increasing AD.
2. When GDP is up, more tax burden on
consumers, discouraging consumption and
decreasing AD.
The more progressive the tax system, the
greater the economy’s built-in stability.
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 Non-Discretionary Fiscal Policy
Unemployment benefits and social service
programs act counter cyclically to stabilize the
economy.
1. When GDP is down, unemployment is higher
and more benefits will be paid out. This helps
to increase AD.
2. When GDP is up, unemployment is low and
fewer benefits will be paid out, decreasing AD.

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 Fiscal Policy Practice
Assume non-discretionary fiscal policy kicks in to
stabilize the economy and the MPC = .8
Price
LRAS 1. How much would
Level
AS transfer payments need
to increase to close gap?
Explain.
$100 Billion.
The multiplier for
transfer payments is
only 4. It is 1 less than
AD2 AD1 the spending
multiplier.
$600 $1000FE
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