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Econ - Essay Example

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Discretionary fiscal policy is one of the tools that the government can use in helping the economy recover from recession. In fact, discretionary fiscal policy is so important that some even suggest for it to have an automatic trigger, where it can combat circumstances that can make it ineffective, such as time lag…
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Download file to see previous pages However, this policy has some disadvantages worth mentioning. For instance, it can cause a more volatile inflation. It can also create an opposite force in the economy when the Federal Reserve wants to do a monetary policy. Moreover, it can potentially widen the national’s budget deficit. Hence, the proposal on having an automatic trigger for discretionary fiscal policy may not be necessary, since the cons outweigh the pros. To have a better understanding on how an automatic trigger of discretionary fiscal policy can affect the economy, some changes in the basic IS-MP model must be made. At present, since there is going to be an automatic increase in government purchase and decrease in taxes whenever output decreases, government purchase, denoted as G, will be made into a negative function of output and taxes, denoted as T, which is a positive function of output. Hence, if there is a decrease in output that is caused by any shock, then government purchase will increase and the tax will decrease immediately. Thus, this modification can be incorporated into the Keynesian cross diagram. Now, the expenditure function will be: E = C(Y-T(Y))+G(Y)+I(r) This change will affect the shape of the expenditure curve in the Keynesian cross diagram. The expenditure curve becomes flatter as output becomes less responsive. By virtue of this new expenditure function, the new IS curve can also be derived by simply looking at the relationship between the level output and the real interest rate. As a result, the new IS curve will be: IS = C(Y-T(Y))+G(Y)+I(r) Following this equation, the IS curve will be steeper because now, the change in output is less responsive. This change in the IS curve will affect how the economy will behave in the presence of an exogenous shock. By having this new modification for the basic IS-MP model, the AD-IA diagram can also be derived, where the new AD curve is steeper compared to the initial one [Figure 1]. Figure 1. Keynesian Cross, IS-MP, and AD-IA Diagrams with an Automatic Trigger for Fiscal Stimulus. By having the newly modified IS curve, output is going to be more stable if there is an IS or MP shock. This can be demonstrated clearly with some examples. For instance, in Figure 2, it can be assumed that the economy is at the potential output and there is a negative IS shock, such as a decrease in consumer confidence. As a result, IS curve will shift leftward and output will fall, forming a negative output gap in the economy. However, since the new IS curve is steeper, the decrease in output is not as large as when there is no automatic trigger for discretionary fiscal stimulus ...Download file to see next pagesRead More
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