1. Fiscal Policy Influences Aggregate Demand
Primary effect of fiscal policy in the short run is on AD
If Fed changes money supply, they influence spending decisions of firms and households and thereby INDIRECTLY affect AD
If Govt. changes tax rates, they influence the spending decisions of firms and households and thereby INDIRECTLY affect AD
If Govt. changes its own spending, it DIRECTLY affects AD

2. If the Govt. increases spending by $20 billion dollars, how far does AD shift? To what extent does GDP increase? The Multiplier Effect suggests that ……. The shift in AD could be larger than the change in Govt. spending (larger than $20 b)

3. GDP +$20 Increase Consumer Electronics Industry. Spending hires more
G buys $20 from Boeing
Boeing increases employment/
income
Increase Consumer Spending/
Electronics
Electronics Industry.
hires more
Increase
Consumer
Spending
GDP
+$20

4. Spending Multiplier MPC
Fraction of extra income that a household consumes rather than saves
If MPC = .80…..it means that…….
For every extra dollar of income the household earns,
the household will spend 0.80…and
save 0.20

5. If MPC is 0.80, then MPS is …..
0.20
If Govt. spends $20b…then that is extra income for Boeing and they will spend…….
$16 b and save $4b…..
and that spending is an extra $16b income for others, of that they will spend…..
$12.8 b and save $3.2 b…….
And that spending is an extra $12.8b income for others, of that they will spend…..
$10.24 b and save $2.56b…..and so on and on….

6. So the multiplier is 1 / (1-MPC) …. or ….
1/MPS
……so the original $20 b of increased govt. spending could generate a total of ……
$100 b ……..how?
$20 b initial increase x 1/.20 ….
$20 b x 5 = $100 b
COULD?????? Why the word “could” ?

7. MPC = .80
What if the govt. purchased $20 b from Boeing, but instead of expanding production and labor force, they simply put the $20 b in savings…….?
The Multiplier is now 1 and the impact on the GDP is and increase of only $20 instead of $100…..
What if they spent $10b of the $20….?

8. The larger the MPC, …the …..
Larger the Multiplier……..Explain

9. Logic of multiplier applies to any component of AD and GDP
A small initial change in (C or I or G or Nx)
Can result in a multiplied effect on AD and GDP

10. Change in Taxes
When the Govt. increase or decrease tax…the multiplier is applied to the change in spending
…but must figure out what the change in spending will be.
If the govt. cuts tax by $10, it increases DI by $10…..but…..
DI is not a part of AD (C,I,G,Nx) …..so…..
a $10 tax cut will increase C by ……
Tax x MPC …… logic…

11. If you now have $10 extra, you will not spend all of it, but rather you will spend a % of the additional income based on MPC….so…..
Tax cut $10 = increase C by ($10 x MPC .80) = $8 and increase savings by $2
Now can apply multiplier to increase in amount of C , and NOT the size of the tax

12. If MPC = .80
Tax cut $10 = Increase DI $10= Increase C $8 Increase GDP $40

13. Crowding Out Effect

14. G increase spending 
AD shifts rt.
money market 
MD shifts right 
IR rise 
Inv. Decreases
AD shifts left

15. G = AD shift right But also causes IR to rise and lowers Inv and AD As G increases spending, the resulting increase in IR “CROWDS OUT” Investment and prevents AD from expanding as much as intended. Can PREVENT expansionary fiscal policy from reaching its goal. *Debate as to the degree of this effect

16. Consider “Crowding In” effect Nx effect
If Gov. uses expansionary fiscal policy to shift AD right
MD shifts right – cause IR to rise
more demand for US dollar on Foreign Exchange Market (more foreign investors want to buy higher interest US bonds)
US dollar APPRECIATES ; US goods are more expensive
US Nx decrease, shift AD left