Fiscal Policy

What is it?

• Is implemented by governments to intervene to manipulate the economy if it is over/underperforming.

• Uses government spending to offset a recessionary gap, and uses taxes to offset an inflationary gap.

• government spending has a direct positive impact on AD,

• When taxes are decreased, it has an indirect impact on AD by increasing disposable income for consumers, which in turn boosts consumption and overall economic activity, but is a smaller magnitude of impact

Occurrences when in a recessionary gap

• Unemployment rises

• prices fall

• productivity falls

Occurrences in an Inflationary gap

• Unemployment is low

• prices are rising

• productivity is rising too fast for firms to keep up

• 
  

Effects of gov spending

• If gov spending increases on goods and services and taxation increases by the same amount, government spending will be greater, as it has a spillover effect, and will benefit everyone since people are paid more by the gov and they can spend more.

Multipliers

• Tax and spending multipliers are both derived from MPC (Marginal propensity to consume) and MPS (Marginal propensity to save); MPC + MPS = 1.

• Spending multiplier = 1/MPS

• Tax multiplier = -MPC/MPS

• Therefor, the tax multiplier is always 1 less than the spending multiplier

• 
  

Suppose the marginal propensity to consume is 0.8. If government spending increases by $15 million and personal income taxes increase by $20 million, what will be the maximum possible change in aggregate demand in the short run?

1. Understand the Components:

   • The marginal propensity to consume (MPC) is 0.8. This means that for every additional dollar of income, consumers spend 80 cents and save 20 cents.

   • Government spending is increasing by $15 million.

   • Personal income taxes are increasing by $20 million.

2. Impact of Government Spending:

   • When government spending increases, it directly boosts aggregate demand. This is calculated using the spending multiplier, which is determined by the formula: Multiplier=1−MPC1​

   • With an MPC of 0.8, the multiplier is 1−0.81​=5.

   • Therefore, the increase in government spending of $15 million results in an increase in aggregate demand of:15×5=75 million dollars

3. Impact of Personal Income Taxes:

   • An increase in taxes generally reduces consumer spending because people have less disposable income. This decrease in spending also affects aggregate demand.

   • The effect of the increase in personal income taxes, taking into account the MPC, is:20×0.8×5=80 million dollars

   • Here, the tax increase reduces aggregate demand by $80 million.

4. Net Change in Aggregate Demand:

   • To find the maximum possible change in aggregate demand, we combine the effects of both government spending and tax changes.

   • The net change is calculated as follows:75−80=−5 million dollars

Thus, the maximum possible change in aggregate demand in the short run is a decrease of $5 million.