Influence of Monetary Policy on AD (Chapter 34 in the Book)

A. How Fiscal Policy Influences AD Fiscal Policy consist of government expenditures on goods and services (G) and taxes (T)

B. Changes in Government Expenditures / Purchases When policy makers change the level of taxes, they shift the AD curve by influencing the spending decisions of firms and households.

Example on Changes in Government Expenditures / Purchases Suppose, for example, that the US department of Defense places a $20 billion order to buy new fighter planes with Boeing. The increase in demand for Boeing planes means an increase G which increases the total quantity of goods and services demanded at each price level that is AD. As a result AD increases and shifts upward.   The question is now is by how much this $20 billion increase in G will increase AD? Will the increase by $20 billion in G increase AD and consequently GDP by $20 billion, more or less?

Example on Changes in Government Expenditures / Purchases At first, we might say that the AD increases or shifts by $20 billion. But, later the AD will tend to increase or shifts by greater or less than $20 billion depending on the greater effect of any of the following two effects that makes the size of the shift in AD differ from the amount of changes in G

Example on Changes in Government Expenditures / Purchases So there are Two Macroeconomic Effects that make the size of the shift in AD different (greater or less) than the amount of change in G.   The Multiplier effect that suggests that the shift in AD could be larger than $20 billion. The Crowding effect that suggests the shift in AD could be smaller than $20 billion. However, both of them agree that an increase in G increases AD and consequently GDP. We now discuss each of the effects in turn.

C. The Multiplier Effect When the government increases in expenditures by $20 billion, the immediate effect is to raise employment, production and profits at Boeing. So: higher earnings or income into the hands of Boeing owners, employees, suppliers and many more. All those people, with extra income, will respond by increasing their own spending on consumer goods. As a result, AD increases more due to increase in Consumption. This increase in C leading to increasing and shifting AD will result in total shift in AD by greater than $20 billion. This greater shift or increase in AD by an amount greater than the amount of increase in G($20 Billion), is what we call Multiplier effect.

C. The Multiplier Effect Hence Multiplier effect represents the additional shifts in AD that results when expansionary fiscal policy (through increase in G or decrease in T) increases income and thereby consumer spending.

C. The Multiplier Effect To sum up: An increase in G by $20 billion initially shifts the AD by exactly $20 billion. But when consumer respond to this increase in G by increasing their spending (C), the AD curve shifts more and hence a greater shift than $20 billion. This is what we call the Multiplier effect.

D. The Multiplier or Accelerator The Multiplier (X) is one of the important concepts of modern macroeconomics. The multiplied effect of government spending on output is called the multiplier (other names: Expenditure Multiplier or government Expenditure Multiplier or Investment Multiplier). So the Multiplier is in general a spending or expenditure multiplier caused by increase in G or I.

D. The Multiplier or Accelerator Hence we define the multiplier as the number by which the change in Investment or Government Spending must be multiplied with in order to determine the resulting change on output. Graphically if I increases or G increases by $20 billion, AD shifts by $20 billion in the immediate effect, but Q increases by greater than $20 billion due to multiplied effect of consumption on AD and Q (See the graph in the next Slide).

The Multiplier Effect Price Level AD3 AD2 2. . . . but the multiplier effect can amplify the shift in aggregate demand. Aggregate demand, AD1 $20 billion 1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion . . . Quantity of Output Copyright © 2004 South-Western

A Formula for the Spending Multiplier The formula for the multiplier is: Multiplier = 1/(1 - MPC) An important number in this formula is the marginal propensity to consume (MPC). It is the fraction of extra income that a household consumes rather than saves.

A Formula for the Spending Multiplier If the MPC is 3/4, then the multiplier will be: Multiplier = 1/(1 - 3/4) = 4 In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.

E. The Crowding – Out Effect The multiplier effect seems to suggest that when the government buys $20 billion of planes from Boeing, the resulting expansion in AD is necessarily greater than $20 billion. Yet another effect is working in the opposite direction. So while an increase in G by $20 billion encourages the AD by a multiplied amount, the crowding effect occurs at the same time.

E. The Crowding – Out Effect What happens is this: As G increases, Incomes of workers and owners of firms increase, Consumption increases. In the financial market, demand for money increases to buy more. Hence DD for money curve increases, which implies increase in interest rates. As interest rates increases, Investment spending decreases. As (I) decreases, consequently AD decreases. And this is what we call crowding-out effect.

The Crowding-Out Effect (a) The Money Market (b) The Shift in Aggregate Demand Interest Price 4. . . . which in turn partly offsets the initial increase in aggregate demand. Rate Money AD2 Level supply AD3 2. . . . the increase in spending increases money demand . . . $20 billion M D2 1. When an increase in government purchases increases aggregate demand . . . r2 3. . . . which increases the equilibrium interest rate . . . r Aggregate demand, AD1 Money demand, MD Quantity fixed Quantity Quantity by the Fed of Money of Output Copyright © 2004 South-Western

E. The Crowding – Out Effect Crowding-out is the effect of a decrease in AD when an increase in G increases the demand for goods and services leading to reducing Investment which will reduce AD.   So the initial impact of an increase in G shifts the AD curve upward by a multiplied amount of the increase in G, but once crowding-out takes place, AD curve shifts leftward.

E. The Crowding – Out Effect To Sum up: When the government increases its purchases by $20 billion, the AD for goods and services could rise by more or less than $20 billion depending on whether the Multiplier effect or the Crowding-out effect is larger.

F. Changes in Taxes Taxes represent the second components of Fiscal Policy. When the government cuts personal income taxes, Income increases, consequently C and S increase. As such AD increases and shifts upward. The size of the shifts in AD resulting from a tax change is also affected by the multiplier and crowding-out effects.

F. Changes in Taxes When the government cuts taxes and stimulates consumer spending and saving. A thing which will increase AD due to increase in C. As to savings, it will lead to increasing investment and consequently initiate a greater increase in AD. Hence the multiplier effect on AD. At the same time, the higher consumption leads to higher money demand that tends to increase interest rates in financial markets. Higher interest makings borrowing more costly which reduces Investment spending and shifts AD to the left. This is the crowding-out effect.

F. Changes in Taxes The size of the shift in AD could be larger or smaller than the tax change depending on the size of multiplier and crowding-out effects.