Fiscal Policy and the MultiplierModule 21

April 2015

Expansionary and Contractionary

An expansionary fiscal policy, like the American Recovery and Reinvestment Act pushed the aggregate demand curve to the right

A contractionary fiscal policy, like Johnson’s tax surcharge, pushes the aggregate demand curve to the left

This module discusses HOW MUCH it shifts and that is determined by the multiplier

1/(1-MPC) is the general multiplier – with MPC meaning marginal propensity to consume

If the marginal propensity to consume is 0.5, the multiplier is 1/(1-.05) = 1/0.5 = 2. Given a multiplier of 2, a $50 billion increase in government purchases of goods and services would result in a real GDP of $100 billion. $50 billion is the initial effect and $50 billion is the subsequent effect.

Same same if the gov spends less, the multiplier would then be negative

Vocabulary

Lump-sum taxes – taxes that don’t depend on the taxpayer’s income – this is rare

Automatic stabilizers – government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands

Transfer payments fall under that automatic category – unemployment benefits increase in a contractionary economy and decrease in an expansionary one

Discretionary fiscal policy – fiscal policy that is the result of deliberate actions by policy makers rather than rules.

Table 21.1 Hypothetical Effects of a Fiscal Policy with a Multiplier of 2Ray and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

1. The MPC I. has a negative relationship to the multiplierII. Is equal to 1III. Represents the proportion of consumers’ disposable income that is

spenta. I onlyb. II onlyc. III onlyd. I and III onlye. I, II, and III only

2. Assume that taxes and interest rates remain unchanged when government spending increases and that both savings and consumer spending increase when income increases. The ultimate effect on real GDP of $100 million increase in government purchases of goods and services will be:a. An increase of $100 millionb. An increase of more than $100 millionc. An increase of less than $100 milliond. An increase of either more than or less than $100 million depending on the

MPCe. A decrease of $100 milllion