Cause/Effect Chain of Expansionary Fiscal Policy

If the MPC = .80 and the Recessionary Gap = $500 Billion, then: The Spending Multiplier = 1/1-MPC or 5; $500 Billion/5 = $100 Billion increase in G. The tax multiplier for a tax cut = MPC/1-MPC = 4; $500 Billion/4 = $125 Billion decrease in taxes.

AD/AS Expansionary Fiscal Policy Problem: Recession Goal: Increase AD & decrease u% Tools: Taxes (T) & Government Spending (G) Actions: Increase G & or Decrease T (move toward or have a budget Deficit) SRAS LRAS PL  PLf  PLe AD1 AD  Ye YF GDPR C & IG↑ (lower taxes will increase C & IG spending), G↑ and/or XN↑ .: AD  .: GDPR↑ & PL↑ .: u%↓ Incomes ↑

Expansionary Fiscal Policy: A Possible Negative Side-effect: “Crowding-out” Since the Federal Govt doesn’t have enough tax revenue to support its expansionary Fiscal Policy, it must borrow or demand more loanable funds. The Loanable Funds Market is where savers (supply) & borrowers (demand) meet. Loanable Funds Market Investment S r% r% r1 r D1 ID D q q1 QLF I1 IG I G↑ and/or T↓ .: Government deficit spends .: DLF  .: r%↑ .: IG↓ because it is more expensive for businesses to get loans to buy capital goods. Since IG is part of AD, AD/GDPr may decrease, partially offsetting Expansionary Fiscal Policy, the goal of which is to increase AD (Crowding-Out Effect)

Market for $ $ S e1 e D1 D Q q q1 Another possible negative side Effect of Expansionary Fiscal Policy Is the Net Export Effect. Foreign investors are attracted to the higher r% in the U.S. caused by deficit spending. Money flows into the U.S. to purchase the higher interest rate investments on bonds, for example. They exchange their currency for dollars. The demand for the dollar goes up and the dollar appreciates. Once the dollar appreciates, Xn (net exports) goes down. This is because U.S. Exports decrease (our products are more expensive) and U.S. Imports go up as Americans have more buying power. Since Xn is part AD (C + IG + G + Xn), AD goes down. Since AD = GDPr, then GDPr goes down. This partially offsets Expansionary Fiscal policy whose goal is to increase AD. (Xn is only 5% of GDPr) $ S e1 e D1 D Q q q1

HOWEVER, Expansionary Fiscal Policy should increase AD overall HOWEVER, Expansionary Fiscal Policy should increase AD overall! The Crowding-Out Effect and Net Export Effect should be overwhelmed by the increase in AD from lowering Taxes (C & IG increase) and increasing Govt Spending to stimulate the economy.

Cause/Effect Chain of Contractionary Fiscal Policy

AD/AS Contractionary Fiscal Policy Problem: Inflation Goal: Decrease AD to decrease PL Tools: Taxes (T) & Government Spending (G) Actions: Increase T & or Decrease G (move toward or have a budget surplus) LRAS PL SRAS  PLe  PLf AD AD1  YF Ye GDPR C↓, IG↓, G↓ and/or XN↓ .: AD  .: GDPR↓ & PL↓ .: u%↑ & Incomes↓

Contractionary Fiscal Policy: Possible Negative Side-effect: “Crowding-In” Loanable Funds Market Investment S r% r% r r1 D ID D1 IG q1 q QLF I I1 G ↓ and/or T ↑ .: Government moves toward budget surplus .: DLF .: r% ↓ .: IG ↑. IG goes up because it is cheaper to borrow more for capital goods purchases. So AD/GDPr/PL increase, partially offsetting Contractionary Fiscal Policy which will decrease AD & PL. (Crowding-In Effect)

Market for $ $ S e e1 D D1 Q q1 q Another possible negative side Effect of Contactionary Fiscal Policy Is the Net Export Effect. Foreign investors are not attracted to the lower r% in the U.S. Less Money flows into the U.S. to purchase investments on bonds, for example. The demand for the dollar goes down and the dollar depreciates. Once the dollar depreciates, Xn (net exports) goes up. This is because U.S. Exports increase (our products are less expensive) and U.S. Imports go down as Americans have less buying power. Since Xn is part AD (C + IG + G + Xn), AD goes up. Since AD = GDPr, then GDPr goes up. This partially offsets Contractionary Fiscal policy whose goal is to deccrease PL/AD. (Xn is only 5% of GDPr) Market for $ $ S e e1 D D1 Q q1 q

HOWEVER, Contractionary Fiscal Policy should decrease AD overall HOWEVER, Contractionary Fiscal Policy should decrease AD overall! The Crowding-In Effect and Net Export Effect should be overwhelmed by the decrease in AD from raising Taxes and decreasing Govt Spending to slow down the economy.