Begin Slides By David Gillette and Kevin Brady Fiscal Policy and the Multiplier Material from this presentation can be found in: Chapter 19 Chapter 20 Interactive Examples To navigate, please click the appropriate green buttons. (Do not use the arrows on your keyboard)

Fiscal Policy and the Multiplier Price Level (P) Aggregate Output (Q) SRAS LRAS QfQf PePe AD An economy is in long-run equilibrium when the aggregate demand curve (AD), short-run aggregate supply curve (SRAS), and long-run aggregate supply curve (LRAS) intersect at the same price level and output level. Question 1: Suppose consumers suddenly cut back on spending. What happens in the economy? Answer Interactive Examples

Fiscal Policy and the Multiplier Price Level (P) Aggregate Output (Q) SRAS LRAS QfQf PePe AD Question 1: Suppose consumers suddenly cut back on spending. What happens in the economy? Answer to Question 1: P1P1 Q1Q1 When consumers reduce spending, the AD curve shifts down and to the left. This results in a short-run equilibrium at a lower output level (Q 1 ) and a lower price level (P 1 ). Next Interactive Examples

Fiscal Policy and the Multiplier Price Level (P) Aggregate Output (Q) SRAS LRAS QfQf PePe AD Question 2: Suppose a new discovery of raw materials lowers input prices throughout the economy. What happens in the economy? Answer Interactive Examples

Fiscal Policy and the Multiplier Price Level (P) Aggregate Output (Q) SRAS LRAS QfQf PePe AD Question 2: Suppose a new discovery of raw materials lowers input prices throughout the economy. What happens in the economy? Answer to Question 2: P1P1 Q1Q1 When input prices decline, the SRAS curve shifts down and to the right. This results in a short-run equilibrium at a higher output level (Q 1 ) and a lower price level (P 1 ). Next Interactive Examples

Fiscal Policy and the Multiplier Price Level (P) Aggregate Output (Q) SRAS LRAS Q1Q1 P1P1 AD In the previous two examples, the economy started at long-run equilibrium. Let’s examine a situation where the economy is below its long-run equilibrium output level, at Q 1. Question 3: The government realizes the economy is operating below equilibrium and decides to implement a stimulus package that includes spending on infrastructure. What effect will this have on our model? PePe QfQf Answer Interactive Examples

Fiscal Policy and the Multiplier Price Level (P) Aggregate Output (Q) SRAS LRAS QfQf PePe AD In the previous two examples, the economy started at long-run equilibrium. Let’s examine a situation where the economy is below its long-run equilibrium output level. Question 3: The government realizes the economy is operating below equilibrium and decides to implement a stimulus package that includes spending on infrastructure. What effect will this have on our model? Answer to Question 3: When the government spends, the AD curve shifts up and to the right. In this graph, the result is a return to the long- run equilibrium at Q f and P e. Next Interactive Examples P1P1 Q1Q1

Fiscal Policy and the Multiplier Price Level (P) Aggregate Output (Q) SRAS LRAS Q1Q1 P1P1 AD In the previous three examples, we looked at the short-run implications of various shocks and government policies. Let’s examine what happens in the long run. The graph to the right shows our economy operating below the long-run equilibrium. Let’s assume we are $1 billion below equilibrium output at Q 1, the spending multiplier is 2, and Congress passes a $1 billion dollar stimulus package. Question 4: What would happen in our model? PePe QfQf Answer Interactive Examples

Fiscal Policy and the Multiplier Price Level (P) Aggregate Output (Q) SRAS LRAS QfQf PePe AD Answer to Question 4: Despite the government’s good intentions, they failed to take into account the effect of the spending multiplier, and so the AD curve shifts past the point where long-run equilibrium would have been, all the way to Q 2 and P 2. The higher level of output is only temporary, however, as workers and suppliers adjust their expectations to the higher price level of P 2. This causes the SRAS curve to shift up and to the left. Prices rise further until workers adjust their inflationary expectations and a new long-run equilibrium is reached at Q f and P 3. Interactive Examples P1P1 Q1Q1 In the previous three examples, we looked at the short-run implications of various shocks and government policies. Let’s examine what happens in the long-run. The graph to the right shows our economy operating below the long-run equilibrium. Let’s assume we are $1 billion below equilibrium output at Q 1, the spending multiplier is 2, and Congress passes a $1 billion dollar stimulus package. Question 4: What would happen in our model? P3P3 P2P2 Q2Q2 The End