1. Unit 4: Monetary and Fiscal Policy1

2. Stabilizers
Begin by drawing a short-run equilibrium with an inflationary gap.
Inflationary gap: fiscal policy should try to shift AD to the left.
contractionary fiscal policy, normally takes one of three forms:
A decrease in government purchases of goods and services
An increase in taxes
A decrease in government transfers
Show how any of these policies would shift the AD curve to the left and GDP closer to Yp.

3. Non-Discretionary Fiscal Policy AKA: Automatic Stabilizers
Legislation that act counter cyclically without explicit action by policy makers.
AKA: Automatic Stabilizers
The U.S. Progressive Income Tax System acts counter cyclically to stabilize the economy.
When GDP is down, the tax burden on consumers is low, promoting consumption, increasing AD.
When GDP is up, more tax burden on consumers, discouraging consumption, decreasing AD.
The more progressive the tax system, the greater the economy’s built-in stability.

4. The Multiplier
Begin by drawing a short-run equilibrium with an inflationary gap.
Inflationary gap: fiscal policy should try to shift AD to the left.
contractionary fiscal policy, normally takes one of three forms:
A decrease in government purchases of goods and services
An increase in taxes
A decrease in government transfers
Show how any of these policies would shift the AD curve to the left and GDP closer to Yp.

5. The Multiplier Effect shows how spending is magnified in the economy.
Why do cities want the Superbowl in their stadium?
An initial change in spending will set off a spending chain that is magnified in the economy.
Example:
Bobby spends $100 on Jason’s product
Jason now has more income so he buys $100 of Nancy’s product
Nancy now has more income so she buys $100 of Tiffany’s product.
The result is an $300 increase in consumer spending
The Multiplier Effect shows how spending is magnified in the economy. 5

6. Effects of Government Spending
If the government spends $5 Million, will AD increase by the same amount?
No, AD will increase even more as spending becomes income for consumers.
Consumers will take that money and spend, thus increasing AD.
How much will AD increase?
It depends on how much of the new income consumers save.
If they save a lot, spending and AD will increase less.
If the save a little, spending and AD will be increase a lot.

7. Marginal Propensity to Consume
Marginal Propensity to Consume (MPC)
How much people consume rather than save when there is an change in income.
It is always expressed as a fraction (decimal).
Change in Consumption
Change in Income
MPC=
Examples:
If you received $100 and spent $50.
If you received $100 and spent $80.
If you received $100 and spent $100.

8. Marginal Propensity to Save
Marginal Propensity to Save (MPS)
How much people save rather than consume when there is an change in income.
It is also always expressed as a fraction (decimal)
Change in Savings
Change in Income
MPS=
Examples:
If you received $100 and save $50.
If you received $100 your MPC is .7 what is your MPS?

9. Because people can either save or consume
MPS = 1 - MPC
Why is this true?
Because people can either save or consume 9

10. How is Spending “Multiplied”?
Assume the MPC is .5 for everyone
Assume the Super Bowl comes to town and there is an increase of $100 in Ashley’s restaurant.
Ashley now has $100 more income.
She saves $50 and spends $50 at Karl’s Salon
Karl now has $50 more income
He saves $25 and spends $25 at Dan’s fruit stand
Dan now has $25 more income.
This continues until every penny is spent or saved
Total change in GDP
= Multiplier x
Initial Change
in Spending

11. Calculating the Spending Multiplier
If the MPC is .5 how much is the multiplier?
Spending
Multiplier OR
If the multiplier is 4, how much will an initial increase of $5 in Government spending increase the GDP?
How much will a decrease of $3 in spending decrease GDP?
MPC = .5 the multiplier is 2
= Multiplier x
Total change in GDP
Initial Change
in Spending 11

12. The Multiplier Effect
Let’s practice calculating the spending multiplier
Spending
Multiplier OR
If MPC is .9, what is multiplier?
If MPC is .8, what is multiplier?
If MPC is .5, and consumption increased $2M. How much will GDP increase?
If MPC is 0 and investment increases $2M. How much will GDP increase?
Conclusion: As the Marginal Propensity to Consumer falls, the Multiplier Effect is less

13. Fiscal Policy Practice
Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .8)
What type of gap?
Contractionary or Expansionary needed?
What are two options to fix the gap?
How much initial government spending is needed to close gap?
LRAS AS
Price level P1 AD
AD1
$ $1000FE
$100 Billion
Real GDP (billions)

14. Fiscal Policy Practice
Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .5)
LRAS
What type of gap?
Contractionary or Expansionary needed?
What are two options to fix the gap?
How much needed to close gap? AS P
Price level
AD1 AD
$80FE $100
-$10 Billion
Real GDP (billions)

15. What about taxing? TM= MPCxMult.
The multiplier effect also applies when the government cuts or increases taxes.
But, changing taxes has less of an impact then government spending. Why?
Expansionary Policy (Cutting Taxes)
Assume the MPC is .75 so the multiplier is 4
If the government cuts taxes by $4 million how much will consumer spending increase?
NOT 16 Million!!
When they get the tax cut, consumers will save $1 million and spend $3 million.
The $3 million is the amount magnified in the economy.
$3 x 4 = $12 Million increase in consumer spending

16. Suppose the government decides to lower income taxes by a lump-sum $1000. The MPC = .90.

17. What about Transfer Payments?
Suppose the government decides to increase transfer payments by a lump-sum of $500.
The MPC = .80

18. Conclusion?
Cutting taxes has a lower multiplied effect than increasing government spending (its indirect)

19. Cutting Tax Practice Price level $10 Billion -$20 Billion
Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .5)
LRAS
1. What to options does the government have?
2. How much should they increase government spending?
$10 Billion
3. How much should they cut taxes? AS
Price level P1
AD2
AD1
$ $100FE
-$20 Billion
Real GDP (billions) 19

20. Multiplier Effect

21. 2008 Practice FRQ 21

22. 2008 Practice FRQ 22