Download III. National Income and Price Discrimination (10

III. National Income and Price Discrimination (10-15%)
A. Aggregate Demand
Marginal Propensity to Consume (MPC) and Save (MPS)
 YD = C + S. After a person pays his taxes, he is left with disposable income Yd that can either
be consumed (C) or saved (S).
 MPC = (Δ C/Δ YD). MPC is the amount by which consumer spending rises if current
disposable income rises by $1 and is the slope of the consumption function.
 MPS = (Δ S/Δ YD). MPS is the Marginal Propensity to Save.
 MPC + MPS = 1.
Consumption Function
YD
0
10
20
30
40



C
5
13
21
29
37
S
MPC (Δ C/Δ YD)
-5
-3
-1
1
3
0.8
0.8
0.8
0.8
MPS (Δ S/Δ YD)
0.2
0.2
0.2
0.2
Autonomous consumer spending is the amount of money a household would spend if it had
no disposable income.
o When YD = 0, household will still consume, drawing down from savings or borrowing. The
$5 of consumption when YD = 0 is called autonomous consumption.
MPC = (Δ C/Δ YD) = (8/10) = 0.8
MPS = (Δ S/Δ YD) = (2/10) = 0.2
o If household receives $1 of additional YD, they will consume 80 cents and save 20 cents.
The consumption function is an equation showing how an individual household’s consumer
spending varies with the household’s current disposable income.
C = A + MPC x YD
A: autonomous consumption or the vertical intercept of the function ($5)
MPC: marginal propensity to consume or the slope of the function (0.8)
The following graph uses the values from the table
above to graph the consumption function:
C = 5 + 0.8YD
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Spending Multiplier. The multiplier is the ratio of total change in real GDP caused by an
autonomous change in aggregate spending to the size of that autonomous change.
 ΔAAS—Autonomous change in aggregate spending is an initial rise or fall in aggregate
spending that causes a series of income and spending changes.
 ΔY is total change in real GDP.
 Multiplier is equal to ΔY/ΔAAS.
ΔY = [1/(1 – MPC)] x ΔAAS
ΔY/ΔAAS = [1/(1 – MPC)]
M = 1/(1 – MPC)
M = 1/MPS
Note: For the AP exam, there has been multiple choice questions on multiplier is equal to
ΔY/ΔAAS.
Example 1. Assume MPC = 0.8.
1. Kevin is a chicken farmer in Orange City. Kevin decides to spend $1000 on some chicken
coops at Anthony’s farm supply shop.
2. Anthony now has $1000 from the sale and spends 80% ($800) on clothes at Jane’s Boss
Clothing. Because let’s face it, Anthony’s a boss.
3. Jane has $800 from the sale and spends 80% ($640) to fix her car at Connor’s gas station.
4. Connor has $640 from the sale and spends 80% ($512) at James’s grocery store. Because
Connor hasn’t been grocery shopping in three months.
5. James has $512 from the sale and spends 80% ($409.60) with Celeste’s catering company.
Because $409.60 can buy a whole lot of cake, and James loves his cake.
After 5 rounds of spending, there is now $2,361.60 in the Orange City economy, more than double
the original injection of spending. If you continue until someone was trying to spend 80% of
nothing, Kevin’s initial $1000 purchase would have multiplied to a total of $5000 in
income/spending.
The spending multiplier can be shown to be equal to:
M = 1/(1-MPC) = 1/(1 – 0.8) = 1/0.2 = 5
M = 1/MPS = 1/0.2 = 5 (Remember, MPC + MPS =1)
Current Disposable Income and Consumption Spending. Movement along the consumption
function. Consumption function is C = A + MPC x YD. Go back to the table and consumption
function we made up above: C = 5 + 0.8YD.
If YD increases from $10 to $20, C increases from $13 to $21. This is a movement upward along the
fixed consumption function. Similarly, if YD decreases from $20 to $10, C decreases from $21 to
$13.
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Shifts of the Aggregate Consumption Function
Changes in Expected Future Disposable Income.
If person knows current disposable income is going
to increase, then that person will increase
consumption. If the person knows current disposable
income is going to decrease, then that person will
decrease consumption. (e.g., job offer)
Changes in Aggregate Wealth. Wealth is
accumulated assets. If the value of your wealth
declines, then consumption will decrease. If the value
of your wealth increases, then consumption will increase. (e.g., stock market investments)
Investment Spending. Booms and busts in investment spending tend to drive the business cycle.
In fact, most recessions originate as a fall in investment spending.
Interest Rate and Investment Spending. When a firm considers investment spending, they are
really doing a benefit-cost analysis on the dollars they are about to spend.
Example 2. A firm is considering building a new factory. This will increase sales, but it will also
require borrowing to fund the investment.
Rate of return = (Revenue – Production Cost)/Production Cost x 100%
Revenue minus production cost is profit. Our production cost here is the investment cost of the
project. The market interest rate is the cost of the investment.
1. Interest rate is cost of borrowed funds.
2. Interest rate is also cost of investing your own funds (no borrowing), since it is income
you’ve given up.
The factory will only go ahead if the firm expects a rate of return higher than the cost of the funds
they would have to borrow to finance that project. If the interest rate increases, fewer projects will
pass that test, and as a result investment spending will be lower. If the interest rate decreases, more
projects will meet the test, and thus, investment spending will be higher. (Inverse relationship
between interest rate and dollars of investment spending.)
Expected Future Real GDP, Production Capacity, and Investment Spending. These factors
increase investment spending at any interest rate.
• Expected Future Real GDP. Ultimately, here, we’re talking about expectations of the firm.
Suppose a firm, Sam’s Furniturama, believed that the economy was going to be booming next
year. Sam may likely increase investment spending in anticipation of increased sales. Businesses
must act now to be able to react to increases in the future; Sam can’t build a couch factory
tomorrow and start production the next day. Sam must begin the factory now to take advantage
of more customers in the coming year and sell, sell, sell.
• Production Capacity. Suppose Sam can produce 100,000 couches if the factory is producing
24/7. The firm’s full capacity is 100,000 couches. Right now, Sam has enough customers to
produce only 50%, or 50,000 units, of full capacity.
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•
o Businesses in this situation would not likely be looking to increase investment. If orders
from customers were to increase, it would be easy to satisfy those orders without increasing
the size of the factory.
Best Case Scenario for a Business to Increase Investment Spending. Businesses near
production capacity with expectations of strong real GDP in the future.
Aggregate Demand Curve. AD is a curve that
shows the relationship between the aggregate price
level and the quantity of aggregate output demanded
by households, firms, the government, and the rest of
the world.
Downward Slope. AD downward slope NOT
due to law of demand. Demand curve for any
individual good shows how the quantity demanded
depends on the price of that good, holding the prices of
other goods and services constant. With AD, we are talking about the aggregate price level rising for all
goods and services in the economy. As such, the wealth and interest rate effects explain the slope.
• Wealth Effect
o When price level decreases, purchasing power of existing financial assets increases, which in
turn increases consumer spending and thus, a downward movement along AD.
o When price level increases, purchasing power of existing financial assets decreases, which in
turn decreases consumer spending and thus, an upward movement along AD.
• Interest Rate Effect
o A lower price level increases the purchasing power of money in your pocket so you need to
hold less money to buy g/s. This decrease in the demand for money holdings puts
downward pressure on interest rates. (See Section IV.)
o A higher price level decreases the purchasing power of money in hand so you need to hold
more money to buy g/s. This increase in the demand for money puts upward pressure on
interest rates. (See Section IV.)
Nominal interest rate = real interest rate + expected inflation. If inflation is expected to fall,
nominal interest rates will also be expected to fall, and vice versa. Lower interest rates increase I and
thus will increase real GDP along AD. Higher interest rates decrease I and thus will decrease real
GDP along AD.
Shifts of the AD. An increase in AD means a shift of AD to the right. A rightward shift happens
when the quantity of aggregate output demanded increases at any given aggregate price level. A
decrease in AD means that AD shifts to the left. A leftward shift implies that the quantity of aggregate
output demanded falls at any given aggregate price level. Regardless of direction of shift, multiplier effect
increases or decreases total spending throughout the economy.
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•
•
•
Changes in Expectations. When consumers and firms are more optimistic about future
economic prospects, they will increase consumption and investment spending, shifting AD to
the right. When consumers and firms are less optimistic about future economic prospects, they
will decrease consumption and investment spending, shifting AD to the left.
Changes in Wealth. If value of assets increases, consumption will also increase. If value of
assets decreases, consumption will also decrease.
o AP Exam: Look for “weak” stock or real estate market as context clues for AD. Weak
stock and real estate markets shift AD leftward.
Size of the Existing Stock of Physical Capital. Firms plan to invest in physical capital when
the stock is being depleted or is insufficient to meet demand for their products.
o If firms have plenty of physical capital already, investment spending will decrease.
o If firms lack physical capital, investment spending will increase.
Government Policies and Aggregate Demand. Government can have a powerful influence on
aggregate demand and that, in some circumstances, this influence can be used to improve economic
performance. The two main ways the government can influence the aggregate demand curve are
through fiscal policy and monetary policy.
• Fiscal Policy is the use of either government spending—government purchases of final goods
and services and government transfers—or tax policy to stabilize the economy. Congress and
the President control fiscal policy.
o Example 3. The economy is a recession. Government can intervene directly or indirectly.
 If government increases spending (G), it will have a direct effect on AD, shift right.
 If government decreases G, it will have direct effect on AD, shift left.
 If government increased taxes, this decreases disposable income, and decreases consumption spending
(C). Decrease in C would shift AD to the left, indirectly affecting AD.
 If government decreased taxes, this increases disposable income, and increases consumption spending.
Increase in C would shift AD to the right, indirectly affecting AD.
• Monetary Policy is the use of changes in the quantity of money or the interest rate to stabilize
the economy. Federal Reserve controls monetary policy.
o Rightward shift. When the Fed increases the quantity of money in circulation, households
and firms have more money, which they are willing to lend out. This drives the interest rate
down at any given aggregate price level, leading to higher investment spending and higher
consumer spending. Thus increasing the quantity of money shifts AD right.
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o Leftward shift. When the Fed decreases the quantity of money in circulation, households
and firms have less money, which they are less likely to lend out. This drives the interest rate
up at any given aggregate price level, leading to lower investment spending and lower
consumer spending. Thus decreasing the quantity of money shifts AD left.
B. Aggregate Supply
Aggregate Supply is the relationship between economy-wide production and the aggregate price
level. In the short run, there is a positive slope (direct) to SRAS curve. In the long run, LRAS curve
is vertical at the level of potential GDP.
SRAS. Economists believe that in the short run,
there is a positive relationship between the aggregate
price level and quantity of aggregate output supplied,
other things equal. In other words, SRAS slopes
upward due to law of supply.
Profit. Profit = Total Revenue – Production Cost.
Example 4. Let’s say that the price of a unit of
output (total revenue) increased, but production cost
of that unit stayed the same. Profit on that unit will rise, and so it will be produced.
Example 5. Let’s say that the price of output (total revenue) increased by 5%, while the production
cost increased 1%. Profit on that unit will also rise, so it will be produced.
If the price of a unit of output is rising faster than the cost of producing that unit of output,
that unit of output will be produced.
Sticky input prices. Sticky input prices are those that don’t rise or fall very quickly in response to a
change in demand for them. (Inelastic).
Sticky wages are nominal wages that are slow to fall even in the face of high unemployment and
slow to rise even in the face of labor shortages. Wages are determined in the labor markets.
• Nominal wages are the dollar amount of the wage paid.
• Real wages are wages that have been adjusted for inflation and its effects on purchasing power.
Example 6. A strong economy. Demand for products is strong and producers are selling their
output quickly, with rising output prices, and profit per unit of output is booming.
• Producers will need to hire more workers, and D for labor shifts to the right.
• Producers reluctant to immediately raise nominal wages and some employees have already
agreed to be paid a lower wage so those wages are fixed for the time being.
• Competition for good workers becomes hardcore and nominal wages begin to rise.
• Price of output rose quickly with stronger demand, but the price of labor (nominal wage) rose
much more slowly.
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Example 7. A weak economy. Demand for products is weak, the economy is in recession.
Producers are selling fewer units of output, with falling output prices, and profit per unit of output is
decreasing.
• Producers will need to reduce number of workers, and D for labor shifts left.
• Producers reluctant to immediately lower nominal wages because they will lose employees.
Some employees have already signed contracts at a higher wage so those wages are fixed for the
time being.
• Labor market becomes weak, with high unemployment, that nominal wages decrease.
• Price of output fell quickly with weaker demand, but the price of labor (nominal wage) fell much
more slowly.
Shifts of SRAS. A shift to the right is an increase in SRAS, and means producers are willing to
produce more aggregate output at any price level. A shift to the left is a decrease in SRAS, and
means aggregate output will decrease at any aggregate price level.
•
•
•
Changes in Commodity Prices. A commodity is a standardized input bought and sold in
bulk quantities (e.g., oil, copper, steel).
o Higher commodity prices make it more costly for firms economy-wide to produce, shifting
SRAS leftward.
o Lower commodity prices make it cheaper for firms economy-wide to produce, shifting
SRAS rightward.
Changes in Nominal Wages
o If nominal wages increase, SRAS will shift to the left.
o If nominal wages decrease, SRAS will shift to the right.
Change in Productivity. If workers are more efficient, they can increase output with same
amount of effort, or be more productive. (e.g., better tools, technology, etc.)
o If productivity increases, SRAS will shift to the right.
o If productivity decreases, SRAS will shift to the left.
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LRAS. Assume that nominal wages under the SRAS curve were not sticky, or enough time has
passed that there has been time to adjust wages. If the price of output increased by 5% and nominal
wages had enough time to increase by 5%, there would be no profit incentive to increase output. All
we would experience would be an increase in the aggregate price level.
LRAS curve is vertical. LRAS intersects the x-axis at
the economy’s potential output, YP. YP is the level of
real GDP the economy would produce if all prices,
including nominal wages, were fully flexible.
Many economists believe that, given enough time, the
economy will adjust back to this level of output.
LRAS shifts gradually to the right over time.
Economy’s potential output increases due to better
technology, better workforce, etc.
From the Short Run to the Long Run. The economy from year to year fluctuates around the
level of potential output (YP). Some years the economy is weak and real GDP lies below YP. Other
years the economy is extremely strong and real GDP lies above YP. In the AD-AS model, the
economy is always operating along the SRAS supply curve, but only sometimes does this coincide
with the intersection of SRAS with LRAS. The AD-AS model predicts that in the long run the
economy will adjust to where SRAS intersects LRAS at YP.
Example 8. Economy is weak and in a recession.
Current real GDP Y1 < YP.
A weak labor market has falling demand for labor.
Unemployment is high. Employers find that they can
get workers to accept lower wages. Nominal wages
fall, and SRAS shifts to the right until current output
Y1 is equal to potential output YP.
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Example 9. Economy is booming. Current real GDP Y2 > YP.
A strong labor market has rising demand for labor.
Unemployment is low. Employers struggle to find
employees. Nominal wages rise and SRAS shifts left
until Y2 is equal to YP.
C. Macroeconomic Equilibrium
AD/AS Model (Short-Run and Long-Run Macroeconomic Equilibrium)
of output, prices begin to rise.
Short-Run Macroeconomic Equilibrium. The
model of AD-AS predicts movement toward
equilibrium. The AD-AS model assumes the
economy is in a state of short-run equilibrium.
• When the price level is above the intersection of
AD and SRAS, there is a surplus of aggregate
output in the economy. When there is a surplus
of output, prices begin to fall.
• When the price level is below the intersection of
AD and SRAS, there is a shortage of aggregate
output in the economy. When there is a shortage
Shifts of AD. An event that shifts AD is known as a demand shock. Demand shocks cause
aggregate output and price level to move in the same direction.
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Example 10. Negative demand shock. A negative demand shock shifts AD to the left.
Economy moves along SRAS from E1 to E2. This leads to lower short-run equilibrium output and a
lower short-run equilibrium aggregate price level.
Andy and his business, Andy Global Enterprises, and lots of others like them, become pessimistic
about future income and future earnings. This pessimism would cause AD to shift to the left. Both
the aggregate price level and real GDP would fall. This would cause a recession. See panel (a) above.
Note that in a negative demand shock, both PE and YE will decrease.
Example 11. Positive Demand Shock. A positive demand shock shifts AD to the right.
Economy moves up along the SRAS from E1 to E2. This leads to higher short-run equilibrium
aggregate output and higher short-run equilibrium aggregate price level.
Justin, who he and others like him have invested heavily in stocks, has just watched the stock market
boom to 25,000 DJA in a week. As such their overall wealth has increased. The increase in wealth
shifts AD rightward. Both the aggregate price level and real GDP would rise. See panel (b) above.
Note that in a positive demand shock, both PE and YE will increase.
Shifts of the SRAS. An event that shifts SRAS is known as a supply shock. Supply shocks cause
aggregate price level and aggregate output to move in opposite directions.
Example 12. Negative Supply Shock. A negative supply shock shifts SRAS to the left.
Economy moves along AD from E1 to E2. This leads to lower aggregate output and a higher
aggregate price level.
Commodity prices rapidly increase. This shifts SRAS to the left. This would increase aggregate
price level and decrease real GDP. See panel (a) above. Note that in a negative demand shock, PE
increases and YE decreases.
Negative supply shocks cause stagflation, which is the combination of inflation and
stagnating/falling aggregate output. Falling aggregate output leads to rising unemployment, and
purchasing power is decreased because of rising prices.
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Example 13. Positive Supply Shock. A positive supply shock shifts SRAS to the right. Economy
moves along AD from E1 to E2. This leads to higher aggregate output and lower aggregate price
level.
Labor productivity increases with better technology. This would shift SRAS to the right. The
aggregate price level would fall and real GDP would increase. Note that in a positive demand shock,
PE decreases and YE increases.
Long-Run Equilibrium. AD-AS model predicts that in the long run, when all prices are flexible,
that the AD, SRAS and LRAS curves will all intersect at potential output YP.
Example 14. Long-Run Equilibrium—Negative Demand Shock.
Note: On AP exam, when explaining demand and supply shocks on FRQs, explain STEP
BY STEP. Do not just jump to the conclusion.
1. Negative demand shock (AD shifts left).
2. In short run, real GDP YE decreases and is below
YP and APL also decreases, creating recessionary
gap (aggregate output below potential output). Labor
market weakened by poor economy and
unemployment increases.
3. Nominal wages decrease. As nominal wages fall,
SRAS begins to shift to the right. Recessionary gap
shrinks because real GDP is rising.
4. Once real GDP returned to YP, economy returns
to long-run equilibrium. Price level decreases further.
Example 15. Long-Run Equilibrium—Positive Demand Shock.
1. Positive demand shock (AD shifts right).
2. In the short run, real GDP YE increases and is
above YP and APL also increases, creating
inflationary gap (aggregate output above potential
output). Labor market strengthened by booming
economy and unemployment decreases.
3. Nominal wages increase. As nominal wages rise,
SRAS begins to shift to the left. Inflationary gap
shrinks because real GDP is falling.
4. Once real GDP returned to YP, economy returns
to long-run equilibrium. Price level increases further.
Inflationary and Recessionary Gaps. Whenever the economy is out of long-run equilibrium,
there is either a recessionary or an inflationary gap. This output gap can be measured as a
percentage between actual aggregate output (YE) and potential output (YP):
output gap = (YE – YP)/YP x 100%.
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Because we’re always trying to get back to LRAS, the output gap always tends to go towards zero.
• Recessionary gap: output gap is negative, nominal wages eventually fall, moving the economy
back to potential output and bringing the output gap back to zero.
• Inflationary gap: output gap is positive, nominal wages eventually rise, also moving the
economy back to potential output and again bringing the output gap back to zero.
In the long run, the economy is self-correcting—shocks to aggregate demand affect aggregate
output in the short run but not in the long run.
Macroeconomic Policy. Long-run adjustment back to YP take a while. Most economists believe
that the government can help expedite the return to full employment and stable prices. (Keynesian
economics). Stabilization policy is the use of government policy to reduce the severity of
recessions and rein in excessively strong expansions.
Policy in the Face of Demand Shocks
• Negative demand shocks cause a recessionary gap. Price level and real GDP fall.
Unemployment is high. Government policy (both fiscal and monetary) is designed to reverse
the decrease in AD. This shortens the duration of a recession.
• Positive demand shocks cause an inflationary gap. Price level and real GDP rise.
Unemployment is low, but inflation is high. Government policy would be geared toward
reversing the increase in AD. This shortens the duration of an inflationary period.
Responding to Supply Shocks. There is very little policymakers can do to reverse a supply shock.
It is much easier to affect spending (through AD) than it is to affect production (through AS).
Example 16. Macroeconomic Policy and Negative Supply Shock. When SRAS shifts to the
left, the concern is inflation and unemployment. Assume the government intervenes in a negative
supply shock by influencing AD through fiscal policy. Refer to panel (a).
• Fiscal policy shifts AD to right. Goal is to fight unemployment. This worsens inflation.
Your citizens hate you.
• Fiscal policy shifts AD to left. Goal is to fight inflation. This worsens unemployment. Your
citizens hate you.
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Example 17. Macroeconomic Policy and Positive Supply Shock. When SRAS shifts to the
right, there is not much to be concerned about. Prices are low and unemployment is low. Assume
the government intervenes in a positive supply shock by influencing AD through fiscal policy. Refer
to panel (b).
• Fiscal policy shifts AD to right. Congratulations. You’ve increased output, but you’ve also
increased prices. You’ve just created inflation where there was none! Now people have to work
more to buy less. You’re a bad economist, but a great Zimbabwean president.
• Fiscal policy shifts AD to left. Congratulations. You’ve decreased output and prices. You’ve
managed to put millions of voters out of work. The good news is that since prices are down,
things are more affordable. Too bad nobody has any cash to actually buy anything. You’re a
bad economist, but an excellent Soviet dictator.
• In short, applying fiscal policy to positive supply shocks is a bad idea.
Fiscal Policy. Fiscal policy is all about taxation and government spending. President proposes a
budget to Congress that includes plans for spending and tax collection. Congress will amend and
approve a budget and it becomes law.
Taxes, Purchases of Goods and Services, Government Transfers, and Borrowing
• Government Spending. G spends money on g/s. Government includes local, state, federal.
• Transfer Payments. G provides transfer payments (SS, Medicare, food stamps, etc.)
• Tax Collection. G must collect money to pay for spending by collecting taxes (sales, income,
property, etc.)
• Borrowing. G can borrow to make up for shortfall in tax revenue that does not pay for all
spending.
Government Budget and Total Spending
• Direct. Government spending is part of GDP (G). As government purchases g/s, this directly
affects GDP and thus AD.
• Indirect. Government can influence consumption spending (C) through taxes and transfers.
Example 18. A person receives income Y from his job. Taxes are paid to the government and
sometimes transfer payments are received by the government. What is left over is YD. YD can now
either be consumed or saved. When YD increases, so does C. When YD decreases, so does C. So
the government can indirectly increase C if it increases YD. Government can indirectly affect C by
cutting taxes or by increasing transfers. This also applies to I through tax policy.
Expansionary and Contractionary Fiscal Policy
• Recessionary gap: fiscal policy should try to shift AD to the right.
o Expansionary fiscal policy
 increase in government purchases of g/s
 increase in government transfers
 cut taxes
• Inflationary gap: fiscal policy should try to shift AD to the left.
o Contractionary fiscal policy
 decrease in government purchases of g/s
 decrease in government transfers
 increase taxes
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Lags in Fiscal Policy
• Recognition lag: Government must realize that recessionary gap exists because economic data
takes time to collect and analyze, and recessions are often recognized only months after they
have begun.
• Decision lag: Government must develop spending plan, which can itself take months,
particularly if politicians take time debating how the money should be spent and passing
legislation.
• Implementation lag: It takes time to spend money. For example, a road construction project
begins with activities such as surveying that don’t involve spending large sums. It may be quite
some time before the big spending begins. By this time, the economy might have already begun
self-correcting back to YP.
Multiplier Effects of an Increase in Government Purchases of Goods and Services.
Government spending and the spending multiplier will work the same way as C and I. Remember,
M = 1/(1 – MPC). The size of the multiplier depends on MPC.
Example 19. Government is experiencing a recessionary gap. MPC = 0.90. Current output is $500
billion below YP and unemployment is increasing. Does the government need to inject $500 billion
of new G into the economy to return to full employment? No.
M = 1/0.1 = 10
Divide the multiplier into $500 billion. $500 billion/10 = $50 billion. An increase of G=$50 billion
will eventually multiply to a 10($50 billion) = $500 billion positive shift of AD to the right.
If you were to have increased $500 billion of new G into the economy, 10($500 billion) = $5 trillion
positive shift of AD to the right. Congratulations, you would have made the Zimbabwean Federal
Reserve very proud. When the revolution comes, you will be first against the wall.
Example 20. Government is experiencing an inflationary gap. MPC = 0.75. Current output is
$800 billion above YP and inflation is hurting the economy.
M = 1/0.25 = 4
Divide the multiplier into $800 billion. $800 billion/4 = $200 billion. A decrease of G=$200 billion
will eventually multiply to a 4×$200 billion = $800 billion negative shift of AD to the left.
If you were to have decreased $800 billion of G, 4($800 billion) = $3.2 trillion negative shift of AD
to the left. Congratulations, you’ve fomented another revolution because since everyone is now
unemployed in the Greatest Depression, they have idle time on their hands. Watch your back.
Multiplier Effects of Changes in Government Transfers and Taxes. Government can
indirectly affect AD through taxes and transfers. However, the impact of tax/transfer policy
indirectly affects real GDP because this type of policy first affects consumer YD. Consumers will
save some of every new dollar of YD. If dollars of new YD are saved, they cannot multiply into
additional spending and income.
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Example 21. Government decides to increase transfer payments by a lump-sum of $500.
MPC = 0.8. When people receive $500 more YD, they will save $100 (20%) and spend $400 (80%).
M = 1/(1 – MPC) = 1/(1 – 0.8) = 1/0.2 = 5
$400 of new spending will now multiply by a factor of 5. $500 increase of transfers will multiply
into $2000 of additional real GDP.
Tax cuts have a similar effect as government transfers. Tax cuts increase YD, which leads to an
increase in C. The overall effect is smaller than that of an equal-sized increase in government
purchases of g/s. The autonomous increase in aggregate spending (AAS) is smaller because
households save part of the amount of the tax cut. This is where the tax multiplier comes in:
TM = MPC/(1 – MPC). Note: the tax multiplier is less than spending multiplier.
Example 22. Government decides to lower income taxes by a lump-sum $1000. MPC = 0.9.
When people get $1000 back, they will save $100 (10%) and spend $900 (90%). Using the
multiplier:
M = 1/(1 – MPC) = 1/(1 – 0.9) = 1/0.1 = 10
$900 of new spending will now multiply by a factor of 10. $1000 tax cut will multiply into $9000 of
additional real GDP.
Now solve using the tax multiplier. First, we use the net change in taxes, $1000. MPC = 0.9.
TM = MPC/(1 – MPC) = 0.9/(1 – 0.9) = 0.9/0.1 = 9
$1000 tax cut will now multiply by a factor of 9. $1000 tax cut will multiply into $9000 of additional
real GDP.
As you can see, the results are identical. Using the tax multiplier eliminates the extra step.
Example 23. Government decides to increase transfer payments by a lump-sum of $500.
MPC = 0.8. When people receive $500 more YD, they will save $100 (20%) and spend $400 (80%).
TM = MPC/(1 – MPC) = 0.8/(1 – 0.8) = 0.8/0.2 = 4
Compare this result to the result in Example 21, which is 5.
$500 government transfer will now multiply by a factor of 4. $500 tax cut will multiply into $2000
of additional real GDP.
As you can see, the results are identical. Using the tax multiplier eliminates the extra step.
Example 24. Government decides to increase income taxes by a lump-sum $1000. MPC = 0.9.
Using the tax multiplier:
TM = MPC/(1 – MPC) = 0.9/(1 – 0.9) = 0.9/0.1 = 9
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$1000 tax increase will now multiply by a factor of 9. $1000 tax cut will multiply into $9000 of
decreased real GDP.
DO NOT use the spending multiplier on tax increases.
Example 25. Real GDP is currently $600 billion above YP and inflation is beginning to dominate
the economy. How could the government adjust taxes or transfers to return the economy to full
employment? How large would this lump-sum adjustment need to be? Assume the MPC = 0.75.
Because the economy is suffering from inflation, taxes need to be raised or transfers need to be cut.
The tax multiplier is TM = MPC/(1 – MPC) = 0.75/(1 – 0.75) = 0.75/0.25 = 3.
To reduce real GDP by $600 billion, taxes need to be increased (or transfers need to be decreased)
by $600 billion/3 = $200 billion.
Example 26. Real GDP is $6 trillion and YP is $7.5 trillion. The government is prepared to pass a
spending package to return the economy to full employment. What kind of spending package
should be passed and how big does it need to be? Assume that the MPC = 0.9.
The economy is in a recession so spending must be increased with expansionary fiscal policy. The
spending multiplier M = 1/(1 – MPC) = 1/(1 – 0.9) = 10.
To increase real GDP by $1.5 trillion, government spending needs to be increased by $1.5 trillion
(the difference between real GDP and YP). $1.5 trillion /10 = $150 billion.
Taxes Effect on the Multiplier
• Discretionary fiscal policy is fiscal policy that is the result of deliberate actions by
policymakers rather than rules.
• Automatic stabilizers are government spending and taxation rules that cause fiscal policy to be
automatically expansionary when the economy contracts, and automatically contractionary when
the economy expands. Non-discretionary.
o AP Exam: Multiple choice questions in the past have asked to identify examples of an
automatic stabilizer, and the answer each time has been progressive tax.
In reality, the eventual impact of discretionary fiscal policy is lessened by the progressive tax system.
Example 27. Assume the economy is in recession and the government has increased G to boost
employment and real GDP. As some consumers find jobs and increased income, they start paying
more taxes and YD decreases. As YD decreases, it slows down the multiplier process. This may
avoid a situation where the big shift in AD creates inflation.
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