Multiplier Effect, Policy Lag & Automatic Stabilizers Fiscal Policy Wrap-up Multiplier Effect, Policy Lag & Automatic Stabilizers

Policy Lags Fiscal policy has long “policy lags” Taxes take time to cut Spending takes time to occur LRAS1 Price Level Real GDP SRAS1 AD1

End result of Fiscal Policy? All make predicting the final effect of FISCAL POLICY Difficult! Multiplier Effect Crowding Out Net Export Effect Automatic Stabilizers State & Local Tax Laws LRAS1 Price Level Real GDP SRAS1 AD2 AD1

The CONFLICT between 2-theories: Crowding Out Multiplier Effect When Government Spending increases: → Multiplier argues for a larger increase in real GDP (AD) → Crowding out argues for a smaller increase in AD (real GDP) We will ASSUME the multiplier always overpowers crowding out!

Net Export Effect Gov’t Borrows $ Real Interest Rates Rise Currency Appreciates $ Export Less Explanation: The US $ appreciates (worth more vs other currencies) Goods become more expensive for foreigners They buy less (NX ↓)

Automatic Stabilizers Considered anything which automatically: Increases deficit during recessionary periods Increases surplus during inflationary periods During Recessions Collect less taxes Pay more unemployment & welfare benefits During Booms Collect more taxes (progressive tax system) Pay less unemployment & welfare benefits

State & Local Taxes States & Local Governments are usually required to balance budget Therefore, they may raise taxes when federal government cuts taxes During recessions! Offsets some of expansionary fiscal policy

Practice Free Response LRAS1 Price Level Real GDP SRAS1 AD1