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Unit 3:
Aggregate Demand and
Supply and Fiscal Policy
1
Review
1. Identify the two types of tool boxes the
government has to fix the economy
2. Explain and give examples of Expansionary
Fiscal Policy
3. Explain and give examples of Contractionary
Fiscal Policy
4. Explain the Multiplier Effect
5. Explain how to calculate the spending
multiplier
6. Name 10 University Mascots
2
Draw and Practice
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .9)
LRAS
Price level
AS
P2
AD1
1. What type of gap?
2. Contractionary or
Expansionary needed?
3. What are two options
to fix the gap?
4. How much needed to
close gap?
AD
-$5 Billion
$50FE $100
Real GDP (billions)
3
Draw and Practice
Congress uses discretionary fiscal policy to the
manipulate the following economy (MPC = .8)
LRAS
Price level
AS
P1
AD2
$800
1. What type of gap?
2. Contractionary or
Expansionary needed?
3. What are two options
to fix the gap?
4. How much initial
government spending
is needed to close gap?
AD1
+$40 Billion
$1000FE
Real GDP (billions)
4
Problems With
Fiscal Policy
5
Problems With Fiscal Policy
•When there is a recessionary gap what two options does
Congress have to fix it?
•What’s wrong with combining both?
Deficit Spending!!!!
•A Budget Deficit is when the government’s
expenditures exceeds its revenue.
•The National Debt is the accumulation of all the budget
deficits over time.
•If the Government increases spending without
increasing taxes they will increase the annual deficit and
the national debt.
Most economists agree that budget deficits are a
necessary evil because forcing a balanced budget would
not allow Congress to stimulate the economy.
6
Paul Solomon Video:
Deficit and Debt
US Debt Clock
7
Explain this cartoon
2003
8
Who ultimately pays for excessive
government spending?
9
Video:
Government Stages Coup
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Additional Problems with Fiscal Policy
1. Problems of Timing
• Recognition Lag- Congress must react to
economic indicators before it’s too late
• Administrative Lag- Congress takes time to
pass legislation
• Operational Lag- Spending/planning takes time
to organize and execute ( changing taxing is
quicker)
2. Politically Motivated Policies
• Politicians may use economically inappropriate
policies to get reelected.
• Ex: A senator promises more welfare and public
works programs when there is already an
inflationary gap.
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Additional Problems with Fiscal Policy
3. Crowding-Out Effect
• In basketball, what is “Boxing Out”?
• Government spending might cause unintended
effects that weaken the impact of the policy.
Example:
• We have a recessionary gap
• Government creates new public library. (AD increases)
• But now consumers spend less on books (AD decreases)
Another Example:
• The government increases spending but must borrow
the money (AD increases)
• This increases the price for money (the interest rate).
• Interest rates rise so Investment to fall. (AD decrease)
The government “crowds out” consumers
and/or investors
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Additional Problems with Fiscal Policy
4. Net Export Effect
International trade reduces the effectiveness
of fiscal policies.
•
•
•
•
•
Example:
We have a recessionary gap so the government
spends to increase AD.
The increase in AD causes an increase in price
level and interest rates.
U.S. goods are now more expensive and the US
dollar appreciates…
Foreign countries buy less. (Exports fall)
Net Exports (Exports-Imports) falls, decreasing
AD.
15
Explain this cartoon
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Activity
17
Congressional Committees
As a group, analyze the situation, identify the
problem, and identify your solution
The Good, the Bad, and the Ugly
Unemployment
Inflation
GDP Growth
Good
6% or less
1%-4%
2.5%-5%
Worry
6.5%-8%
5%-8%
1%-2%
Bad
8.5 % or more
9% or more
.5% or less
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1.) 1933
Situation:
• GDP fell -1.2%
• Inflation rate= -.5%
• Unemployment Rate=25%
Your Solution:
What actually happened:
• FDR increased public works via the New
Deal programs.
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2.) 1944
Situation:
• GDP grew 8%
• Inflation rate= 3.7%
• Unemployment Rate=1.2%
Your Solution:
What actually happened:
• War ended the next year and government
orders for war materials decreased.
• Many public works programs were
discontinued
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3.) 1980
Situation:
• GDP fell -0.3%
• Inflation rate= 13.5%
• Unemployment Rate=7.1%
Your Solution:
What actually happened:
• The next year, President Regan and
congress lowered taxes on individuals and
corporations by about 30%. (Supply-side
Economics)
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4.) 2003
Situation:
• GDP fell 0.5%
• Inflation rate= 1.5%
• Unemployment Rate=12.0%
Your Solution:
What actually happened:
• Congress voted to give tax cuts to
citizens. (Bush Tax Cuts)
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