Price level LRAS. If they spend 100 billion, AD would look like this P 1 AD 2 AD 1. Real GDP (billions)

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1 Fiscal Policy 1

2 Ø Ø Ø Price level Type of gap? and what type of policy is best? Recessionary Gap Expansionary Fiscal Policy What should the government do to spending? Increase government spending to increase AD How much should the government spend? They should NOT spend 100 billion! LRAS AS If they spend 100 billion, AD would look like this P 1 AD 1 AD 2 $400 $500 FE Real GDP (billions)

3 The Multiplier Effect Why do countries want the Olympics? An initial change in spending will set off a spending chain that is magnified in the economy. Example: Jackie Chan spends $100 on John s product John now has more income so he buys $100 of Mary s product Mary now has more income so she buys $100 of Tim s product. The result is an $300 increase in consumer spending The Multiplier Effect shows how spending is magnified in the economy.

4 Effects of Government Spending The government spends $20 Million How much will AD increase? It depends on how much of the new income consumers save. If they save a lot, spending and AD by a little If the save a little, spending and AD will increase by a lot

5 MPC Ø Marginal Propensity to Consume Ø How much people spend rather than save. Examples: 1.If you received $100 and spent $50. MPC =.50 2.If you received $100 and spent $80. MPC =.80 3.If you received $100 and spent $100. MPC = 1 MPS Ø Marginal Propensity to Save Ø How much people save rather than spend. Examples: 1.If you received $100 and save $50. MPS =.50 2.If you received $100 your MPC is.7 what is your MPS? MPS =.3

6 MPC + MPS = 1 MPS = 1 - MPC MPC = 1 - MPS You can either save or spend(consume) money. FYI: Burning it is illegal.

7 How is Spending Multiplied? Assume the MPC is.5 for everyone Assume the Super Bowl comes to town and there is an increase of $100 in Ashley s restaurant. Ashley now has $100 more income. She saves $50 and spends $50 at Karl s Salon Karl now has $50 more income He saves $25 and spends $25 at Dan s fruit stand Dan now has $25 more income. This continues until every penny is spent or saved Total change in GDP = Multiplier x Initial Change in Spending

8 Calculating the Spending Multiplier If the MPC is.5 how much is the multiplier? Spending Multiplier OR Ø If the multiplier is 4, how much will an initial increase of $5 in Government spending increase the GDP? Ø How much will a decrease of $3 in spending decrease GDP? Total change in GDP = Multiplier x Initial Change in Spending

9 The Multiplier Effect Spending Multiplier OR 1. If MPC is.9, what is multiplier? 2. If MPC is.8, what is multiplier? 3. If MPC is.5, and consumption increased $2M. How much will GDP increase? 4. If MPC is 0 and investment increases $2M. How much will GDP increase? 5. If the MPS is 0 and investment increases by $4M. How much will GDP increase? Conclusion: As the Marginal Propensity to Consume falls, the Multiplier Effect is less

10 Real GDP (billions) Fiscal Policy Practice Congress uses discretionary fiscal policy to the manipulate the following economy (MPC =.8) Price level P 1 LRAS AS A. What type of gap? B. Contractionary or Expansionary needed? C. What are two options to fix the gap? D. How much initial government spending is needed to close gap? $500 $1000FE AD 2 AD 1 $100 Billion

11 Price level Fiscal Policy Practice Congress uses discretionary fiscal policy to the manipulate the following economy (MPC =.5) P 2 LRAS AS A. What type of gap? B. Contractionary or Expansionary needed? C. What are two options to fix the gap? D. How much needed to close gap? $80FE $100 AD 1 AD Real GDP (billions) -$10 Billion

12 Expansionary Policy (Cutting Taxes) Ø MPC is.75 - Multiplier is 4 Ø The government cuts taxes by $4 million how much will consumer spending increase? NOT 16 Million! Ø When they get the tax cut, consumers will save $1 million and spend $3 million. Ø The $3 million is the amount magnified in the economy. Ø $3 x 4 = $12 Million increase in consumer spending Tax Multiplier Contractionary Policy (Increasing Taxes) Ø MPC is.75 - Multiplier is 4 Ø The government increases taxes by $4 million how much will consumer spending decrease? NOT 16 Million! Ø When they get the tax cut, consumers will save $1 million and spend $3 million. Ø The $3 million is the amount magnified in the economy. Ø $3 x 4 = $12 Million decrease in consumer spending

13 Price level Cutting Tax Practice Congress uses discretionary fiscal policy to the manipulate the following economy (MPC =.5) P 1 LRAS AS Ø How much should they increase government spending? $10 Billion Ø How much should they cut taxes? -$20 Billion AD 2 AD 1 $80 $100FE Real GDP (billions)

14 Multiplier Effect

15 2008 Practice FRQ

16 2008 Practice FRQ