Fiscal Policy Influences Aggregate Demand Primary effect of fiscal policy in the short run is on AD If Fed changes money supply, they influence spending decisions of firms and households and thereby INDIRECTLY affect AD If Govt. changes tax rates, they influence the spending decisions of firms and households and thereby INDIRECTLY affect AD If Govt. changes its own spending, it DIRECTLY affects AD

If the Govt. increases spending by $20 billion dollars, how far does AD shift? To what extent does GDP increase? The Multiplier Effect suggests that ……. The shift in AD could be larger than the change in Govt. spending (larger than $20 b)

GDP +$20 Increase Consumer Electronics Industry. Spending hires more G buys $20 from Boeing Boeing increases employment/ income Increase Consumer Spending/ Electronics Electronics Industry. hires more Increase Consumer Spending GDP +$20

Spending Multiplier MPC Fraction of extra income that a household consumes rather than saves If MPC = .80…..it means that……. For every extra dollar of income the household earns, the household will spend 0.80…and save 0.20

If MPC is 0.80, then MPS is ….. 0.20 If Govt. spends $20b…then that is extra income for Boeing and they will spend……. $16 b and save $4b….. and that spending is an extra $16b income for others, of that they will spend….. $12.8 b and save $3.2 b……. And that spending is an extra $12.8b income for others, of that they will spend….. $10.24 b and save $2.56b…..and so on and on….

So the multiplier is 1 / (1-MPC) …. or …. 1/MPS ……so the original $20 b of increased govt. spending could generate a total of …… $100 b ……..how? $20 b initial increase x 1/.20 …. $20 b x 5 = $100 b COULD?????? Why the word “could” ?

MPC = .80 What if the govt. purchased $20 b from Boeing, but instead of expanding production and labor force, they simply put the $20 b in savings…….? The Multiplier is now 1 and the impact on the GDP is and increase of only $20 instead of $100….. What if they spent $10b of the $20….?

The larger the MPC, …the ….. Larger the Multiplier……..Explain

Logic of multiplier applies to any component of AD and GDP A small initial change in (C or I or G or Nx) Can result in a multiplied effect on AD and GDP

Change in Taxes When the Govt. increase or decrease tax…the multiplier is applied to the change in spending …but must figure out what the change in spending will be. If the govt. cuts tax by $10, it increases DI by $10…..but….. DI is not a part of AD (C,I,G,Nx) …..so….. a $10 tax cut will increase C by …… Tax x MPC …… logic…

If you now have $10 extra, you will not spend all of it, but rather you will spend a % of the additional income based on MPC….so….. Tax cut $10 = increase C by ($10 x MPC .80) = $8 and increase savings by $2 Now can apply multiplier to increase in amount of C , and NOT the size of the tax

If MPC = .80 Tax cut $10 = Increase DI $10= Increase C $8 Increase GDP $40

Crowding Out Effect

G increase spending  AD shifts rt. money market  MD shifts right  IR rise  Inv. Decreases AD shifts left

G = AD shift right But also causes IR to rise and lowers Inv and AD As G increases spending, the resulting increase in IR “CROWDS OUT” Investment and prevents AD from expanding as much as intended. Can PREVENT expansionary fiscal policy from reaching its goal. *Debate as to the degree of this effect

Consider “Crowding In” effect Nx effect If Gov. uses expansionary fiscal policy to shift AD right MD shifts right – cause IR to rise more demand for US dollar on Foreign Exchange Market (more foreign investors want to buy higher interest US bonds) US dollar APPRECIATES ; US goods are more expensive US Nx decrease, shift AD left