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College Preparatory Program • Saudi Aramco Government & Fiscal Policy Macroeconomics Tips Fiscal Policy and the Multiplier Effect KEY POINTS TO REMEMBER: (AGGREGATE DEMAND and GDP/OUTPUT are synonymous in accordance with the Expenditure Model for GDP) AD = C + G+ I + (X-M) {Aggregate Demand = Consumption + Govt. Expenditures + Investment + Net Exports} When one component of AD is increased it translates into an overall increase in AD much greater than the original increase. (Multiplier Effect) Scenario : Government wants to increase AD by 10 Billion Dollars a. Without increasing Taxes government decides to increase G by $50 Billion. b. Inevitably, due to the Multiplier Effect they will overshoot this amount easily. G↑ How? A. Might infuse this amount into Education. Build new schools Hire more teachers Buy new books Upgrade educational technology such as computers, access to internet, etc… B. Or, they might spend it on healthcare. Build new hospitals Hire more nurses, doctors… Give them pay raises, Upgrade medical technology capital, etc… KEY POINT REMINDER : As a result, this $50 billion dollars will generate into an amount a great deal more than the original amount. College Preparatory Program • Saudi Aramco Government & Fiscal Policy Example: Let’s assume that the Government is going to give nurses, across the board, a 15% pay raise. Nurses will most likely spend a certain percentage of the increased amount of disposable income in several ways: Buy new clothes Spend the money in restaurants Buy a new mobile phone, computer, etc… Eat steak and lobster more often, and so on Perhaps take that vacation which was previously unaffordable, and so on REMEMBER: AD = C + G+ I + (X-M) KEY POINTS: A. A rise in G↑ translates into a rise in C↑ since the extra spending generated by the pay raise will increase consumption. B. As a result of a rise in Consumption, stores, restaurants, etc.. may have to hire on more workers to meet the increased demand. Therefore I (Consumption rises). The added employees will also spend some of their earnings. C. Businesses may find that they need to upgrade their capital, i.e., buy new equipment in order to meet the increase in demand. Restaurants upgrade their kitchens with new stoves, etc..Clothing stores invest in new stock, and so on. Therefore Investment increases. I↑ D. However, some of that money may be spent in the foreign market, i.e., buying property overseas, taking a vacation overseas, etc…so (X_M), net exports would decrease since imports (M) increase (This would be considered a Leakage) E. Some of the increased disposal income may also be saved. (also a leakage) So the equation after the infusion of $50 billion may look like this: AD↑ = C↑+ G↑ + I↑ + (X-M)↓ (imports increase then net exports decrease) Ceretus Paribus, the increase in any of the variables of Consumption, Government Spending, Investment and Net Exports will shift the AD Curve to the right. College Preparatory Program • Saudi Aramco KEY POINTS: Government & Fiscal Policy How much of an increase in AD government wants to change is difficult to gauge and predict. Too much growth and increase in employment may lead to undesirable high levels of inflation. (see graph analysis below for discussion on this point) Price level AD2 P2 P1 AD1 P3 AD3 Output Y3 Y1 Y2 At P3, AD is low. Price level is low, unemployment high due to decreased output. (refer to Phillips Curve below) At P2, AD and employment are high, pushing the price level up (inflation rises accordingly) At P1, AD is at the equilibrium point. inflation Phillips Curve unemployment KEY POINTS: If government infuses too much money into the economy it may cause very high inflation, as at P3. Notice that pushing the economy from P1 t P2 may increase employment at the cost of a higher inflation rate. (refer to the Phillips Curve above to review the inverse relationship between unemployment and the inflation rate) If government infuses money when the economy is functioning at P3 the trade-off in increased price level (inflation) when moving it to P1 (equilibrium point) is acceptable. IN SUMMARY: Government may use Fiscal Policy to either increase AD (output) or decrease it. However, how successful a particular fiscal policy may be can be unpredictable. It is not an exact science.