4 HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND Fiscal policy – taxing, spending, and borrowinginfluences saving, investment, and growth in the long run.In the short run, fiscal policy primarily affects the aggregate demand.What are challenges to fiscal policy implementation?
5 Changes in Government Purchases There are two macroeconomic effects from the change in government purchases:The multiplier effectThe crowding-out effect
6 The Multiplier EffectGovernment purchases are said to have a multiplier effect on aggregate demand.Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar.
7 Figure 4 The Multiplier Effect PriceLevelAD3AD2but the multipliereffect can amplify theshift in aggregatedemand.Aggregate demand,AD1$20 billion1. An increase in government purchasesof $20 billion initially increases aggregatedemand by $20 billion . . .Quantity ofOutput
8 A Formula for the Spending Multiplier The formula for the multiplier is:Multiplier = 1/(1 – MPC)An important number in this formula is the marginal propensity to consume (MPC).It is the fraction of extra income that a household consumes rather than saves.
9 A Formula for the Spending Multiplier If the MPC = 3/4, then the multiplier will be:Multiplier = 1/(1 – 3/4) = 4In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.
10 The Crowding-Out Effect Fiscal policy may not affect the economy as strongly as predicted by the multiplier.An increase in government purchases causes the interest rate to rise.What are the consequences of a higer interest rate?
11 The Crowding-Out Effect This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.
12 Figure 5 The Crowding-Out Effect (a) The Money Market(b) The Shift in Aggregate DemandInterestPricewhich in turnpartly offsets theinitial increase inaggregate demand.RateMoneyAD2LevelsupplyAD3the increase inspending increasesmoney demand . . .$20 billionMD21. When an increase in governmentpurchases increases aggregatedemand . . .r2whichincreasestheequilibriuminterestrate . . .rAggregate demand, AD1Money demand,MDQuantity fixedQuantityQuantityby the Fedof Moneyof Output
13 Changes in TaxesWhen the government cuts personal income taxes, it increases households’ take-home pay.Households save some of this additional income.Households also spend some of it on consumer goods.Increased household spending shifts the aggregate-demand curve to the right.
14 Changes in TaxesThe size of the shift in aggregate demand resulting from a tax change is affected by the multiplier and crowding-out effects.It is also determined by the households’ perceptions about the permanency of the tax change.
15 What are the Types of Taxes? Proportional TaxesA tax with a constant % paid regardless of incomeFlat taxProgressive TaxesA tax where the % paid in taxes increases as income increasesU.S. Personal Income TaxRegressive TaxesThe lower your income the higher % you pay in taxesSales Tax
17 USING POLICY TO STABILIZE THE ECONOMY Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946, which states that:“it is the continuing policy and responsibility of the federal government to…promote full employment and production.”
18 The Case for Active Stabilization Policy The Employment Act has two implications:The government should avoid being the cause of economic fluctuations.The government should respond to changes in the private economy in order to stabilize aggregate demand.What economic school of thought does this follow? Who would be against active stablization?
19 The Case against Active Stabilization Policy Some economists argue that monetary and fiscal policy destabilizes the economy.Monetary and fiscal policy affect the economy with a substantial lag – rational expectations!!!They suggest the economy should be left to deal with the short-run fluctuations on its own.
20 Automatic Stabilizers Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.Automatic stabilizers include the tax system and some forms of government spending.