KW_Macro_Ch_12_Sec_02_Fiscal_Policy_The_Multiplier -...

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>> Fiscal Policy Section 2: Fiscal Policy and the Multiplier chapter 12 An expansionary fiscal policy, like Japan’s program of public works, pushes the aggregate demand curve to the right. A contractionary fiscal policy, like Lyndon Johnson’s tax surcharge, pushes the aggregate demand curve to the left. For policy makers, however, knowing the direction of the shift isn’t enough: they need esti- mates of how much the aggregate demand curve is shifted by a given policy. To get these estimates, they use the concept of the multiplier, which we introduced in Chapter 10. Multiplier Effects of an Increase in Government Purchases of Goods and Services Suppose that a government decides to spend $50 billion building bridges and roads. The government’s purchases of goods and services will directly increase total spend- ing on final goods and services by $50 billion. But as we learned in Chapter 10, there
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2 CHAPTER 12 SECTION 2: FISCAL POLICY AND THE MULTIPLIER will also be an indirect effect because the government’s purchases will start a chain reaction throughout the economy. The firms producing the goods and services pur- chased by the government will earn revenues that flow to households in the form of wages, dividends, interest, and rent. This increase in disposable income will lead to a rise in consumer spending. The rise in consumer spending, in turn, will induce firms to increase output, leading to a further rise in disposable income, which will lead to another round of consumer spending increases, and so on. In Chapter 10 we introduced the concept of the multiplier: the ratio of the change in GDP caused by an autonomous change in aggregate spending to the size of that autonomous change. We saw there that in the simplest case (where there are no taxes or international trade, so that any change in GDP accrues entirely to households, and the aggregate price level and the interest rate are fixed) the multiplier is 1/(1 MPC ). Recall that MPC is the marginal propensity to consume, the fraction of an additional dollar in disposable income that is spent. For example, if the marginal propensity to consume is 0.6, the multiplier is 1/(1 0.6) = 1/0.4 = 2.5. An increase in government purchases of goods and services is an example of an autonomous increase in aggregate spending. Its effect is illustrated in Figure 12-6. Given a multiplier of 2.5, a $50 billion increase in government purchases of goods and services will shift the AD curve rightward from AD 1 to AD 2 , a distance repre- senting an increase in real GDP of $125 billion at a given aggregate price level. Of that $125 billion, $50 billion is the initial effect from the increase in G, and the remaining $75 billion is the subsequent effect arising from the increase in consumer spending. What happens if government purchases of goods and services are instead reduced?
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This note was uploaded on 04/10/2008 for the course ECONOMICS 103 taught by Professor Sheflin during the Spring '08 term at Rutgers.

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KW_Macro_Ch_12_Sec_02_Fiscal_Policy_The_Multiplier -...

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