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Macroeconomics: Fiscal Policy and short run effects of fiscal and monetary policies

 

  • Fiscal Policy: government spending and taxation, aimed at expending or contracting the level of macroeconomic activity in a nation.
    • A tax increase (decrease) will raise (lower) households' disposable income, leading to more (less) consumption. Furthermore, firms will increase (decrease) the number of investment as they get to keep a larger (smaller) share of their profits.
    • An increase (decrease) in government spending affects the variable G that defines the aggregate demand. Government spending also leads to a change in household income, affecting the level of consumption.
  • Tax multiplier: just like any multiplier so far, it is just the sum of a converging geometric series:
    • Say the MPC is equal to 70%, then it must be the case that the MPS is 30%. Thus, the tax multiplier, t, is equal to about -2.32. In other words, for every dollar that goes to tax revenue, total spending decreases by about 2.32 dollars.
    • Note that a tax decrease would be negative, and thus have a positive effect on the economy. For example, the government implements a tax cut of 10 million dollars, assuming the same MPC and MPS from the paragraph above, then the total effect is 23.2 million dollars. Then, AD goes up by 23.3 million dollars.
  • As a reminder, the spending multiplier is equal to:
  • Note that since the tax and spending multipliers are both converging geometric series, it must be the case that neither the MPC or the MPS is equal to 1, then we can conclude that m will always be bigger than t.
Short run effects of fiscal and monetary policies:


  • See that a contractionary fiscal (or monetary) policy shifts the AD curve to the left and an expansionary fiscal (or monetary) policy shifts the AD curve to the right.
  • Note that fiscal and monetary polices can also have an effect on the aggregate supply curve.
    • Crowding out effect of expansionary fiscal policy: if the government borrows money in order to increase its spending (or in order to keep the same level of spending given a tax cut), then this causes the interest rate to go up in the private sector. This will ultimately decrease the number of private investment, pushing the aggregate supply curve to the left.
    • An expansionary monetary policy decreases the interest rate for the private sector which then shifts the AS curve to the right. 
    • Note that usually the supply side effect of both the fiscal and monetary policy are usually much smaller than their impact on the aggregate demand. It is often okay to assume that only the AD is affected.

Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 181-191.

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