Economics Lecture 101 - Counter Cyclical Fiscal Policy - for Dummies: Course 27

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Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and influence a nation's economy. It is the sister strategy to monetary policy through which a central bank influences a nation's money supply. These two policies are used in various combinations to direct a country's economic goals. Here we look at how fiscal policy works, how it must be monitored and how its implementation may affect different people in an economy. Before the Great Depression, which lasted from Sept. 4, 1929 to the late 1930s or early 1940s, the government's approach to the economy was laissez-faire. Following World War II, it was determined that the government had to take a proactive role in the economy to regulate unemployment, business cycles, inflation and the cost of money. By using a mix of monetary and fiscal policies (depending on the political orientations and the philosophies of those in power at a particular time, one policy may dominate over another), governments are able to control economic phenomena. How Fiscal Policy Works Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, curbs inflation (generally considered to be healthy when between 2-3%), increases employment and maintains a healthy value of money. Fiscal policy is very important to the economy. For example, in 2012 many worried that the fiscal cliff, a simultaneous increase in tax rates and cuts in government spending set to occur in January 2013, would send the U.S. economy back to recession. The U.S. Congress avoided this problem by passing the American Taxpayer Relief Act of 2012 on Jan. 1, 2013. Quantitative Easing is also a type of fiscal policy, implemented in Europe in several iterations in response to the eurozone debt crisis. Read more: What Is Fiscal Policy? | Investopedia Follow us: Investopedia on Facebook as no competitors in its industry. It reduces output to drive up prices and increase profits. By doing so, it produces less than the socially optimal output level and produces at higher costs than competitive firms. Oligopoly: An oligopoly is an industry with only a few firms. If they collude, they reduce output and drive up profits the way a monopoly does. However, because of strong incentives to cheat on collusive agreements, oligopoly firms often end up competing against each other. Monopolistic competition: In monopolistic competition, an industry contains many competing firms, each of which has a similar but at least slightly different product. Restaurants, for example, all serve food but of different types and in different locations. Production costs are above what could be achieved if all the firms sold identical products, but consumers benefit from the variety. Finding Market Equilibrium Price and Quantity Buyers and sellers interact in markets. Market equilibrium occurs when the desires of buyers and sellers align exactly so that neither group has reason to change its behavior. The market equilibrium price, p*, and equilibrium quantity, q*, are determined by where the demand curve of the buyers, D, crosses the supply curve of the sellers, S. At that price, the amount that the buyers demand equals the amount that the sellers offer. image0.jpg In the absence of externalities (costs or benefits that fall on persons not directly involved in an activity), the market equilibrium quantity, q*, is also the socially optimal output level. For each unit from 0 up to q*, the demand curve is above the supply curve, meaning that people are willing to pay more to buy those units than they cost to produce. There are gains from producing and then consuming those units. Identifying Market Failures Sometimes markets fail to generate the socially optimal output level of goods and services. Several prerequisites must be fulfilled before perfect competition can work properly and generate that output level. Causes of market failure include the following: Externalities caused by incomplete or nonexistent property rights: Without full and complete property rights, markets are unable to take all the costs of production into account. Asymmetric information: If a buyer or seller has private information that gives her an edge when negotiating a deal, the opposite party may be too suspicious for both parties to reach a mutually agreeable price. The market may collapse, with no trades being made. Public goods: Private firms can’t make money producing certain goods or services because there’s no way to exclude nonp

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