Fiscal Policy Graph Practice Key

T↓ so C↑, .: PL↑, AD  .: GDPR↑, and .: u%↓ & National Incomes↑ # 1 Scenario A This is an example of Expansionary Fiscal Policy to fight recession. AD/AS SRAS LRAS PL  PLf  PLe AD1 AD  Ye YF GDPR T↓ so C↑, .: PL↑, AD  .: GDPR↑, and .: u%↓ & National Incomes↑

Explanation of # 1 Scenario A The decrease in personal taxes should increase C or Consumption spending. People would have more money from their paychecks to spend. Since C is part of AD, then AD increases. Since AD and GDPr are the same thing, GDPr increases. With an increase in output (more products sold) or GDPr, more employees are needed, so the unemployment rate or u% goes down. With more people employed and earning a paycheck, national incomes increase.

This is the “Crowding Out” Effect This is the “Crowding Out” Effect. A negative side-effect of Expansionary Fiscal Policy. Loanable Funds Market Investment SLF r% r% # 2 Scenario A r1 r DLF 1 ID DLF IG q q1 QLF I1 I T↓ .: Government deficit spends .: DLF  .: r%↑ .: Quantity of Investment ↓

Explanation of # 2 Scenario A The decrease in personal taxes will cause the government to move toward a budget deficit. In order to maintain its spending level with reduced tax revenues from the tax cut, the government will need to demand more Loanable Funds. The demand for Loanable Funds represents borrowing. No bank actually loans money to the Federal Government, so what is does is sell government securities (bonds) to the public. In order to sell them, it offers a higher interest rate (r%). The increased demand for Loanable Funds will raise the r%. Translating this to the Investment Graph, the Quantity of Investment will decrease as businesses will find it more expensive to obtain loans for capital goods. Thus, the quantity of investment will decrease. HERE BUSINESSES (IG) ARE BORROWING MONEY. IT IS MORE EXPENSIVE TO BORROW WHEN INTEREST RATES INCREASE, SO FEWER LOANS ARE TAKEN OUT. It reduces or “Crowds Out” Investment Spending. This goes slightly against what Expansionary Fiscal Policy is trying to accomplish (increase AD and reduce unemployment).

# 3 Scenario A Market for U.S. Dollar This is the “Net Export Effect” of Expanisonary Fiscal Policy. A negative side-effect. Market for U.S. Dollar $ S e1 e D 1 D Q£ q q1 D$  .: e ↑ & Q$↑ .: U.S. $ appreciates. So Exports decrease, Imports Increase, causing Xn to decline. Therefore AD and GDPr decrease slightly.

Explanation of # 3 Scenario A The increased demand for Loanable Funds will raise the r%. This will result in higher interest rates on financial investments in the U.S. (i.e. higher bond interest rates). When we invest money, like putting money into a savings account, we want higher interest rates. We earn more interest income this way. Foreign financial investors are attracted to the higher r% in the U.S.. As such, they will supply more of their currency to the U.S. to exchange them for U.S. dollars. These dollars would be used to buy U.S. government securities. Therefore, the demand for the U.S. dollar increases, causing it to appreciate. After appreciation, U.S. Exports become more expensive to foreigners and decrease. U.S. Imports will increase, however, as Americans have more buying power. Thus Xn (Exports – Imports) will decrease. Since Xn is part of AD/GDPr, both will decline. This goes slightly against what Expansionary Fiscal Policy is trying to accomplish (increase AD and reduce unemployment).

An example of Contractionary Fiscal Policy to fight inflation. # 1 Scenario B AD/AS LRAS PL SRAS  PLe  PLf AD AD1  YF Ye GDPR An example of Contractionary Fiscal Policy to fight inflation. AD decreases, PL decreases, GDPr decreases, unemployment rises, and National Incomes decline.

Explanation of # 1 Scenario B The decrease in government spending will decrease AD. G is part of GDPr and since AD and GDPr are the same thing, GDPr decreases. With a decrease in output fewer products sold) or GDPr, fewer employees are needed, so the unemployment rate or u% goes up. With fewer people employed and earning a paycheck, national incomes decrease.

# 2 Scenario B. This is the “Crowding In” Effect a negative side-effect of Contractionary Fiscal Policy. Loanable Funds Market Investment SLF r% r% r r1 DLF 1 ID DLF IG q1 q QLF I I1 G ↓.: Government moves toward budget surplus .: DLF .: r% ↓ .: Quantity of Investment goes ↑

Explanation of # 2 Scenario B The decrease in government spending will cause the government to move toward a budget surplus. Since it is spending less, the Federal Government will demand fewer Loanable Funds. The decreased demand for Loanable Funds will lower the r%. Translating this to the Investment Graph, the Quantity of Investment will increase as businesses will find it cheaper to obtain loans for capital goods. Thus, the quantity of investment will increase. HERE BUSINESSES (IG) ARE BORROWING MONEY. IT IS LESS EXPENSIVE TO BORROW WHEN INTEREST RATES DECREASE, SO MORE LOANS ARE TAKEN OUT. Hence, investment spending is “Crowded-In.” This goes slightly against what Contractionary Fiscal Policy is trying to do (reduce AD and inflation).

# 3 Scenario B Market for U.S. Dollar This is the “Net Export effect of Contractionary Fiscal Policy. A negative Side-effect. Market for U.S. Dollar $ S e e1 D D 1 Q q1 q D$  .: e ↓ & Q¥ ↓ .: $ depreciates causing Exports to increase, Imports to decrease and Xn to increase. As such, AD and GDPr increase slightly.

Explanation of # 3 Scenario B The decreased demand for Loanable Funds will reduce the r%. This will result in lower interest rates on financial investments in the U.S. (i.e. lower bond interest rates). When we invest money, like putting money into a savings account, we want higher interest rates. We earn more interest income this way. Foreign financial investors are not attracted to the lower r% in the U.S.. As such, they will demand fewer U.S. dollars, thus causing it to depreciate. After depreciation, U.S. Exports become cheaper to foreigners and increase. U.S. Imports will decrease, however, as Americans have less buying power. Thus Xn (Exports – Imports) will increase. Since Xn is part of AD/GDPr, both will increase. This goes slightly against what Contractionary Fiscal Policy is trying to accomplish (reduce AD and inflation)