ECC1100 Lecture 8: How Fiscal Policy Influences Aggregate Demand
How Fiscal Policy Influences Aggregate Demand
ā¢ Fiscal policy: the setting of the level of government spending and taxation by government
policymakers
ā¢ Changes in Government Purchases:
o When policymakers change the money supply or the level of taxes, they shift the
aggregate-demand curve indirectly by influencing the spending decisions of firms or
households.
o By contrast, when the government alters its own purchases of goods and services, it
shifts the aggregate-demand curve directly.
ā¢ The Multiplier Effect: the additional shifts in aggregate demand that result when
expansionary fiscal policy increases income and thereby increases consumer spending
o Marginal propensity to consume (MPC)āthe fraction of extra income that a
household consumes rather than saves.
o For example, suppose that the marginal propensity to consume is 3ā4. This means that
for every extra dollar that a household earns, the household spends $0.75 (3ā4 of the
dollar) and saves $0.25.
o Multiplier finds the demand for goods and services that each dollar of government
purchases generates.
Multiplier = 1/ (1 ā MPC).
o The size of the multiplier depends on the marginal propensity to consume. While an
MPC of
Ā¾ leads to a multiplier of 4, an MPC of Ā½ leads to a multiplier of only 2. Thus, a larger
MPC means a larger multiplier. To see why this is true, remember that the multiplier
arises because higher income induces greater spending on consumption. With a larger
MPC, consumption responds more to a change in income, and so the multiplier is
larger.
o The multiplier is an important concept in macroeconomics because it shows how the
economy can amplify the impact of changes in spending. A small initial change in
consumption, investment, government purchases, or net exports can end up having a
large effect on aggregate demand and, therefore, the economyās production of goods
and services.
ā¢ The Crowding-Out Effect: the offset in aggregate demand that results when expansionary
fiscal policy raises the interest rate and thereby reduces investment spending
Document Summary
This means that for every extra dollar that a household earns, the household spends sh. 75 (3 4 of the dollar) and saves sh. 25: multiplier finds the demand for goods and services that each dollar of government purchases generates. Multiplier = 1/ (1 mpc): the size of the multiplier depends on the marginal propensity to consume. Leads to a multiplier of 4, an mpc of leads to a multiplier of only 2. To see why this is true, remember that the multiplier arises because higher income induces greater spending on consumption. Mpc, consumption responds more to a change in income, and so the multiplier is larger: the multiplier is an important concept in macroeconomics because it shows how the economy can amplify the impact of changes in spending. At the same time, higher income leads to higher money demand, which tends to raise interest rates: higher interest rates make borrowing more costly, which reduces investment spending.
