The Influence of Monetary and Fiscal Policy on Aggregate Demand CHAPTER 21 The Influence of Monetary and Fiscal Policy on Aggregate Demand This chapter focuses on the short-run effects of fiscal and monetary policy. (Students learned about the long-run effects of fiscal and monetary policy in previous chapters.) Most students find this chapter a bit less difficult than the preceding one. This chapter also reinforces concepts introduced in the preceding one, gives students more exposure to and practice with the model of aggregate demand and aggregate supply, and sheds light on contemporary policy issues students may be reading about in the newspapers. Running short on time? Consider omitting the slides titled “Using Policy to Stabilize the Economy,” “The Case For Active Stabilization Policy,” and “The Case Against Active Stabilization Policy” near the end of this file. This issue is one of the debates in the final chapter, “Six Debates Over Macroeconomics Policy”, which covers the same material. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Fiscal Policy and the AD Setting the level of government spending and taxation by government policymakers Expansionary fiscal policy An increase in G and/or decrease in T, shifts AD right Contractionary fiscal policy A decrease in G and/or increase in T, shifts AD left Fiscal policy has two effects on AD... © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

The Multiplier Effect Example: If the government buys $20b of planes from Boeing, Boeing’s revenue increases by $20b. This is distributed to Boeing’s workers (as wages) and owners (as profits or stock dividends). These people are also consumers and will spend a portion of the extra income. This extra consumption causes further increases in aggregate demand. Notation: $20b = $20 billion © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

A $20b increase in G initially shifts AD to the right by $20b. 1. The Multiplier Effect A $20b increase in G initially shifts AD to the right by $20b. The increase in Y causes C to rise, which shifts AD further to the right. Multiplier effect: the additional shifts in AD that result when fiscal policy increases income and thereby increases consumer spending Y P AD3 AD2 AD1 P1 Y1 Y2 Y3 $20 billion © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 4

Marginal Propensity to Consume How big is the multiplier effect? Depends on how much consumers respond to increases in income. Marginal propensity to consume, MPC=ΔC/ΔY Fraction of extra income that households consume rather than save Example If MPC = 0.8 and income rises $100, C rises $80. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

A Formula for the Multiplier Notation: ΔG is the change in G, ΔY and ΔC are the ultimate changes in Y and C Y = C + I + G + NX identity ΔY = ΔC + ΔG I and NX do not change ΔY = MPC ΔY + ΔG because ΔC = MPC ΔY solved for ΔY This slide uses simple algebra to derive a formula for the simple spending multiplier. If you do not wish to cover this derivation, you can skip to the next slide, which just shows the formula for the multiplier. However, you will need to explain the “delta” notation, as the formula on the next slide includes the terms G and Y. The multiplier 1 1 – MPC ΔY = ΔG © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 6

A Formula for the Multiplier The size of the multiplier depends on MPC. E.g., if MPC = 0.5 multiplier = 2 if MPC = 0.75 multiplier = 4 if MPC = 0.9 multiplier = 10 A bigger MPC means changes in Y cause bigger changes in C, which in turn cause bigger changes in Y. 1 1 – MPC ΔY = ΔG The multiplier If you skipped the previous slide, which shows the algebraic derivation of the multiplier, then you may need to explain the delta notation to students. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 7

Other Applications of the Multiplier Effect The multiplier effect: Each $1 increase in G can generate more than a $1 increase in aggregate demand. Also true for the other components of GDP. Example: Suppose a recession overseas reduces demand for U.S. net exports by $10b. Initially, aggregate demand falls by $10b. The fall in Y causes C to fall, which further reduces aggregate demand and income. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Changes in Taxes A tax cut Another factor: households perception Increases households’ take-home pay Households respond by spending a portion of this extra income, shifting AD to the right The size of the shift is affected by the multiplier and crowding-out effects Another factor: households perception Permanent tax cut – large impact on AD Temporary tax cut – small impact on AD The textbook gives a nice example: the first President Bush reduced federal income tax withholding to stimulate consumer spending to combat the recession. However, this was just a temporary reallocation of tax liability and, consequently, had a very small affect on aggregate demand. See the textbook for more details. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

A Formula for the Tax Multiplier The size of the multiplier again depends on MPC. - MPC 1 – MPC ΔY = ΔT The tax multiplier A bigger MPC means changes in Y cause bigger changes in C, which in turn cause bigger changes in Y. If you skipped the previous slide, which shows the algebraic derivation of the multiplier, then you may need to explain the delta notation to students. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. 10