 Dropping a rock in a pond has a ripple effect  Fiscal Policy works in a similar way: multiplier effect  Any purchase made by the government has an initial effect, secondary effect and so on  EX. Government pays a worker $1000 for his services  Economy output rises by $1000, and worker’s revenue increases  Worker uses $500/$1000 to buy a Canadian product, increasing economy’s total output again  Canadian product worker spends $250/$500 on a Canadian product, increasing economy’s total output, and so on… The Spending Multiplier

 Marginal Propensity to Consume is the effect on domestic consumption of a change in income  MPC answers the question: “If income increases by this amount, how much extra will be spent on domestic goods and services?” Marginal Propensity to Consume

 Marginal Propensity to Withdraw is the effect of a change in income on withdrawals Marginal Propensity to Withdraw

MPC and MPW Together

 Economy increases by $1000  Economy increases by $500  Economy increases by $250  Economy increases by $125 Spending Multiplier  Government pays Worker A $1000 for work done  Worker A spends $500 to buy object from Worker B; remaining $500 to savings  Worker B spends $250 to buy object from Worker C; remaining $250 to savings  Worker C spends $125 to buy object from Worker D; remaining $125 to savings When you continue this and add all the amounts, economy increases by $2000 Note: MPW = 0.5 since everyone withdraws half their amount

 Thus, the total change in output ($2000) became twice as much as the initial change in spending ($1000) Spending Multiplier Cont’d Recall: MPW = 0.5

 REGIONAL FOCUS  During a recession, new government purchases or programs can be targeted to regions where unemployment is the highest  In an inflation, spending cuts and tax hikes can be concentrated on the regions where inflation is at its worst  IMPACT ON SPENDING  The first spending adjustment is assured, since the government initiates the change Benefits of Fiscal Policy

 DELAYS  Although automatic stabilizers work promptly to stabilize economy, discretionary measures can be delayed by:  Recognition Lag: time to realize that a policy is needed  Decision Lag: time needed to form and implement a good policy  Impact Lag: time between a policy’s implementation and having an effect on the economy  POLITICAL VISIBILITY  Expansionary fiscal policy is popular when an election is coming up, so that taxes get cut and government increases spending  This is actually not good, as an increase in taxes may be needed, but it is regarded by voters as being negative Drawbacks of Fiscal Policy

 PUBLIC DEBT  Reluctance to increase taxes and decrease government spending is related to Canada’s public debt  Total amount owed by the federal government as a result of its past borrowing  Public Debt Charges are amounts that are paid out each year by the federal government to cover the interest charges on its public debt Drawbacks of Fiscal Policy Cont’d