Ricardian equivalence, the multiplier effect, automatic stabilizers, and fiscal policy issues. A quick summary

What is Ricardian equivalence: Ricardo believed that people were smart and forward looking.  He developed a theory that is now called the Ricardian equivalence theorem.  The theory basically says that if taxes are decreased or spending is increased, then the government incurs a debt.  The government must pay this debt off in the future with either increased taxes, or decreased spending.  People are smart and realize this, so they save the money they receive from the government today and invest it, so they can pay back the government in the future.  Under Ricardo’s view, fiscal policy would have no effect on aggregate demand because the increase in spending caused by the government would be matched 1 for 1 by decreases in spending from the private sector.

Some economists believe in Supply-Side effects:  Supply side economists argue that a decrease in taxes will spur economic growth.  Economic growth will thus increase the tax base, and therefore taxes collected.  So a decrease in taxes can potentially lead to an increase in tax revenue.  This phenomena is represented by an inverse U shaped curve, known as the Laffer curve and shown below:

Supply side economists argue that a decrease in taxes increases the opportunity cost of leisure because more money can be made by working.  This causes people to work more and therefore more gets produced in the economy.  More production means higher tax revenue.

Finally, economists often argue whether government spending or a reduction in taxes is better for the economy.  According to “Economics Today” by LeRoy Miller, a dollar reduction in taxes increases GDP by $1.40 to $3.00 while the same dollar increase in spending only raises GDP by $0.70.

Dynamic AD-AS model:
This model is our typical AD-AS model that allows for increases in real GDP and inflation over time.  The increases in Real GDP are a result of the LRAS curve and the SRAS curve shifting right, while the inflation is caused by the AD curve shifting more right (because of the money supply increasing).

Multiplier Effect:
The multiplier effect assumes that the initial increase in government spending or decrease in taxes will have a larger effect on the shifting of the AD curve than just the initial effect.  This is because consumers will spend the money they receive from government spending or taxes in the economy.  Because of this spending more consumers will have money, and they will spend the additional money.  This effect of continuing spending in the economy as a result of an initial increase in government spending or decrease in taxes is called the multiplier effect.

Fiscal policy and time lags:
It takes time to recognize, plan and enact fiscal policy.
Recognition time lag: The time it takes to understand and learn about current trends in the economy.

Action time lag: The time between recognizing a problem, and enacting a policy to solve it.  Most of the lag occurs from bureaucratic processes.

Effect time lag:  The time between enacting the policy, and when the effects are felt in the economy.

Remember it as: Recognize, act, and effect.

Automatic stabilizers:
Built in stabilizing policy include automatic policy measures that help stabilize the economy during business cycles.  These include:

Taxes:  During a recession you make less money, and you also pay less in taxes.  The fact that we pay a percentage of our income in tax helps make this a stabilizing effect.  We also have a progressive tax system (marginal tax rates rise as income rises) so the less we make, the less of a percentage we pay.

Unemployment compensation and income transfers:  When someone loses their job, they qualify for unemployment payments, welfare and social security.  But during good times people will receive less of these benefits increasing tax revenues and decreasing government spending.

Fiscal policy in practice:
During normal times, the time lags will motivate congress to not enact many types of fiscal policy.  However, during abnormal times, such as during wars and depressions or recessions, congress will use fiscal policy to stimulate the economy and hopefully shift the AD curve to the right with the hope to attain potential real GDP levels.

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