Download Fiscal Policy and the Multiplier Effect

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)
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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:
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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
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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:
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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.