APMacro: AD AS Model and Fiscal Policy

Fiscal Policy
Fiscal policy consists of deliberate changes in government spending, taxes, or some combination of both to promote full employment, price level stability and economic growth. How does a change in government spending (G) or taxes (T) result in a change in output or national income (Y)? Multipliers express the ration of a change in aggregate output to a change in tan or spending policy, and fiscal policy works through the spending multiplier.

Suppose that the government decides to increase spending. An increase in G means that AD goes up by the same amount; firms increase production by the same amount to satisfy this increase in demand.Y increases by the same amount that G increases. An increase in production also means this new output gets sold and generates income for the producers. They in turn spend this income (investments) and consumption increases. As a result, demand increases again and so does production. This process keeps repeating until the final increase in output is much greater than the initial increase in G. How much greater depends on the spending multiplier. It describes increases and decreases in the effectiveness of fiscal policy.

The spending multiplier helps us to determine how a change in G will affect GDP. It is described by the following equation:

Government spending multiplier = 1 / (1 – MPC)
Real GDP = change in G x spending multiplier

MPC means marginal propensity to consume. MPC describes the proportion of each additional dollar of increase that will go toward consumption expenditures. MPS, the marginal propensity to save reveals the proportion of the additional dollar that is saved. MPC plus MPS is equal to 1. When MPC is high (close to a), this represents a high level of consumption; similarly the closer MPSis to 1, the higher the proportion of savings.

Information to evaluate the effect of a change in government spending: find the change in real GDP demanded if the MPC = 0.8

spending multiplier = 1 / (1 – MPC) = 1 / (1 – 0.8) = 1 / 0.2 = 5
real GDP = G x 5

We see that if the MPC is 0.8, any increase in government spending (G) will bring about a five times greater increase in output (Y). The same is true of a decrease in G. So if G increases by 100, Y increases by 5(100) = 500. If G decreases by 50, Y decreases by 5(50) = 250. To increase Y, the government must increase spending and to decrease Y, the government must decrease spending.

If the government wants to increase Y, should it increase or decrease taxes? Suppose the government decreases taxes. When T falls, national disposable income increases. Disposable income increases when people pay less in taxes and have more money to spend, creating an increase in consumption. However, consumption does not go up by the same amount that income increases. If taxes decrease by $100 million and income therefore goes up by $100 million, people will not spend all of this extra income. They will spend some of it and save some of it. The ratio of saving to spending depends on the MPS and the MPC.

When T falls, national disposable income goes up and results in an increase in consumption. An increase in consumption means that AD increases and firms produce more to meet this increase in demand. This new output gets sold and generates more income for the producers; they then spend this money (investments), causing another increase in consumption, another increase in AD and another increase in production. Once again, we have an economic effect that goes beyond the amount of the original change. The tax multiplier can help us evaluate the effect of this change in taxes.

Tax multiplier = – MPC / (1 – MPC)
real GDP = T x tax multiplier

Notice that this multiplier is negative. This means that if the government aims to increase Y, it should lower taxes. Also not all tax relief income gets spent; a certain percentage of it will be saved, depending upon the MPC. So the absolute value of the tax multiplier is smaller than that of the government spending multiplier.

If we set MPC equal to 0.8, as we did for the government spending multiplier:

Tax multiplier = – MPC / (1 – MPC) = -0.8 / (1 – 0.8) = -0.8 / 0.2 = -4
real GDP = T x -4

For the same MPC, the absolute value of the tax multiplier is smaller than that of the government spending multiplier. The absolute value of the tax multiplier when the MPC is 0.8 is 4, whereas the value of the government spending multiplier is 5. This means that to bring about the same increase in Y, the government will meed to make a larger change in T than it would have needed to make in G.

So if T falls by 100, Y will increase by 400: -4(-100) = 400. If T increases by 50, Y will fall by 200: -4(50) = -200. The negative sign indicates a decrease in T or Y, while a positive number indicates that it is rising. The tax multiplier is negative, which means that an increase in net taxes will lead to a decrease in real GDP demanded. The positive value of the government spending multiplier means that an increase in government spending leads to an increase in real GDP demanded.

1) Chapter 11 p.225 #2, 3,5
2) Learnerator: Production Possibilities Curve #1-20, Inflation #1-30, Unemployment #1-30



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