Free-response/problem
1. Explain why Keynesians believe that
recessions begin and persist and why
fiscal policy is necessary in remedying
them.
2. Use the ideas of neoclassical economists
(Monetarists) and classical economists
(Austrians) to evaluate the theory you
explained in #1.
•
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Changes in Government Purchases
• There are two macroeconomic effects from the
change in government purchases:
• The multiplier effect
• The crowding-out effect
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The Multiplier Effect
• Government purchases are said to have a
multiplier effect on aggregate demand.
• Each dollar spent by the government can raise the
aggregate demand for goods and services by more
than a dollar.
• This multiplier effect refers to the additional shifts
in aggregate demand that result when expansionary
fiscal policy increases income and thereby increases
consumer spending.
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The Multiplier Effect
Price
Level
2. . . . but the multiplier
effect can amplify the
shift in aggregate
demand.
$20 billion
AD3
AD2
Aggregate demand, AD1
0
1. An increase in government purchases
of $20 billion initially increases aggregate
demand by $20 billion . . .
Quantity of
Output
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A Formula for the Spending Multiplier
• The formula for the multiplier is:
Multiplier = 1/(1 - MPC)
• An important number in this formula is the
marginal propensity to consume (MPC).
• It is the fraction of extra income that a household
consumes rather than saves.
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A Formula for the Spending Multiplier
• If the MPC is 3/4, then the multiplier will be:
Multiplier = 1/(1 - 3/4) = 4
• In this case, a $20 billion increase in
government spending generates $80 billion of
increased demand for goods and services.
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Balanced Budget Multiplier
Example
MPC = .75
T and G by $20 billion
What is the net increase in GDP?
What is the multiplier?
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Balanced Budget Multiplier = 1
• Given an MPC of .75, a tax increase of $20
billion will lower consumption by $15 billion.
Because the multiplier is 4, GDP will decline
by $60 billion.
• The $20 billion increase in government
spending will increase GDP by $80 billion.
• The net increase in GDP is $20 billion. The
multiplier is 1.
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The Crowding-Out Effect
• Fiscal policy may not affect the economy as
strongly as predicted by the multiplier.
• An increase in government purchases causes
the interest rate to rise.
• A higher interest rate reduces investment
spending.
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The Crowding-Out Effect
• This reduction in investment demand that
results when a fiscal expansion raises the
interest rate is called the crowding-out effect.
• The crowding-out effect tends to dampen the
effects of fiscal policy on aggregate demand.
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The Crowding-Out Effect
(a) The Money Market
Interest
Rate
(b) The Shift in Aggregate Demand
Price
Level
Money
supply
2. . . . the increase in
spending increases
money demand . . .
$20 billion
4. . . . which in turn
partly offsets the
initial increase in
aggregate demand.
r2
3. . . . which
increases
the
equilibrium
interest
rate . . .
AD2
r
AD3
M D2
Aggregate demand, AD1
Money demand, MD
0
Quantity fixed
by the Fed
Quantity
of Money
0
1. When an increase in government
purchases increases aggregate
demand . . .
Quantity
of Output
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Loanable Funds Market
The Crowding-Out Effect
• When the government increases its purchases
by $20 billion, the aggregate demand for goods
and services could rise by more or less than $20
billion, depending on whether the multiplier
effect or the crowding-out effect is larger.
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