13.1 Fiscal Policy and the AD–AS Model

What is fiscal policy?

Fiscal policy is the use of government spending (G) and taxation (T) to influence economic outcomes like employment, inflation, and growth.

What are the two components of fiscal policy?

Government spending (G) and taxes (T).

What is discretionary fiscal policy?

Changes in G or T that require new legislation and presidential/Congress approval.

Consists of deliberate changes in government spending and taxation designed to achieve full employment, control inflation, and encourage economic growth

What is nondiscretionary fiscal policy?

Automatic changes in G or T based on existing laws (e.g., unemployment benefits).

When is expansionary fiscal policy used?

During a recession or when real GDP is below potential.

What does expansionary fiscal policy involve?

Increasing G and/or decreasing T to boost aggregate demand.

How does the multiplier effect work in expansionary policy?

Initial spending or tax cuts lead to multiplied increases in consumption and GDP.

Why must tax cuts be larger than spending increases to have the same effect?

Because part of the tax cut is saved, not spent.

When is contractionary fiscal policy used?

During demand-pull inflation when GDP exceeds full employment.

What does contractionary fiscal policy involve?

Decreasing G and/or increasing T to reduce aggregate demand.

What happens if the government overdoes contractionary policy?

It can cause a recession by reducing GDP below potential.

How does the multiplier affect contractionary policy?

A small change in G or T can lead to a large decrease in aggregate demand.

What is contractionary fiscal policy used for?

To reduce demand-pull inflation by decreasing aggregate demand.

What are the tools of contractionary fiscal policy?

Decreasing government spending (G), increasing taxes (T), or both.

What is the goal of contractionary fiscal policy?

To eliminate the inflationary GDP gap and stabilize prices.

If the inflationary GDP gap is $12 billion and the multiplier is 4, how much should G decrease?

$3 billion, because $3B × 4 = $12B reduction in aggregate demand

Why shouldn't the government reduce G by $5 billion in this case?

It would cause a $20B drop in AD, overshooting the target and creating a recession.

What happens if the price level is inflexible downward?

The full change in AD affects real GDP, not prices—risking recession if policy is too aggressive.

If MPC = 0.75, how much must taxes increase to reduce AD by $12 billion?

$4 billion, because $4B × 0.75 = $3B drop in consumption, and $3B × 4 = $12B total AD reduction.

Tax multiplier: - MPC / 1 - MPC
Change in AD = Tax multiplier x change in taxes

Why does part of a tax increase not reduce consumption?

Because some of it reduces saving (MPS × tax increase), not spending.

How does a $1.5B cut in G and a $2B tax increase reduce AD by $12B?

• G cut: $1.5B × 4 = $6B

• T hike: $2B × 0.75 = $1.5B → $1.5B × 4 = $6B

• Total: $6B + $6B = $12B

What is the goal of increased government spending in expansionary fiscal policy?

To shift the aggregate demand curve rightward and restore full-employment GDP.

If the government increases spending by $5 billion and MPC = 0.75, what is the total impact on AD?

$20 billion, because the multiplier is 4 (1 / (1 - 0.75)).

Why does the AD curve shift more than the initial $5 billion?

Because of the multiplier effect—each dollar spent leads to multiple rounds of new spending.

What happens to real GDP and unemployment when AD shifts from AD₂ to AD₁?

Real GDP rises from $490B to $510B, and unemployment falls.

How does a $6.67 billion tax cut lead to a $5 billion increase in consumption?

Because MPC = 0.75 → 0.75 × $6.67B = $5B spent, $1.67B saved.

What is the total impact on AD from a $5 billion increase in consumption with a multiplier of 4?

$20 billion increase in aggregate demand.

Why must tax cuts be larger than spending increases to have the same effect?

Because part of the tax cut is saved, not spent—only the MPC portion boosts consumption.

How does a $1.25B increase in G and a $5B tax cut produce a $5B initial spending boost?

• G adds $1.25B directly

• T adds $3.75B (0.75 × $5B)

• Total = $5B initial increase in spending

What is the total AD shift from this $5B initial increase with a multiplier of 4?

$20 billion rightward shift in aggregate demand.

The manipulation of taxes and federal spending in order to stimulate the economy or reduce inflation is known as expansionary or contractionary_________

Policy

The discretionary fiscal policy used to stimulate the economy is called ______ fiscal policy

Expansionary

Discretionary fiscal policy consists of deliberate changes in government spending and taxation designed to do which of the following?

• Achieve full employment

• Control inflation

• Encourage economic growth

When an economy's output is _________ its potential output, the gap is known as a recessionary gap.

Below

A budget deficit is government spending in excess of what?

Tax revenues

If the economy starts out with a balanced federal budget, a subsequent expansionary fiscal policy will create a _______

Budget deficit
A balanced budget means government spending = tax revenue

Expansionary fiscal policy means the government increases spending or cuts taxes to stimulate economy

Spending > revenue, means deficit

To induce an increase in consumption through a tax cut, the smaller the MPC is, the _______ the tax cut needs to be

larger
If MPC is small, people save more and spend less of any tax cut.

Restrictive fiscal policy is also known as ______ fiscal policy

Contractionary

When demand-pull inflation occurs, what kind of fiscal policy may help control it?

Contractionary

When tax revenues exceed government spending, it is called _______

Budget surplus

The _______ the MPC, the greater the tax cut needed to induce a specific initial increase in consumption.

Lower
Lower MPC → people spend less → you need a bigger tax cut to get the same consumption boost.

When the economy faces demand-pull inflation, fiscal policy should move toward a government budget __________

Surplus
• A budget surplus means the government is collecting more in taxes than it spends.

• This reduces aggregate demand by:

• Cutting spending

• Or raising taxes

• That helps cool down the economy and reduce inflationary pressure

To correct a(n) ________ GDP gap, the government would need to shift the aggregate demand curve to the left.

Inflationary
• It happens when actual GDP is higher than potential GDP.

• The economy is overheating — too much spending, high demand, and rising prices.

• This leads to demand-pull inflation

What happens to the price level when aggregate demand (AD) declines?

The price level remains the same.

The price level can remain stuck at its old level even when aggregate demand declines.

True.
Prices tend to be "sticky" downward. This means that the tendency in the price level is not to decline, even when aggregate demand does decline.