Demand Management
Policy: The Fiscal
Approach
Chapter 11
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11 - 2
Introduction
 The
multiplier model highlights the role
of aggregate demand management
policies.
 These include monetary policy and
fiscal policy.
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11 - 3
Introduction
policy – the deliberate change in
either government spending or taxes to
stimulate or slow down the economy.
 Fiscal
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11 - 4
Introduction
 Expansionary
fiscal policy involves
decreasing taxes or increasing
government spending.
 Contractionary fiscal policy involves
increasing taxes or decreasing
government spending.
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11 - 5
The Story of Fiscal Policy
 An
economy needs a countershock to
get out of a deep recession.
 Countershock – a jolt in the opposite
direction of the shift in aggregate
demand to get the multiplier working in
reverse.
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11 - 6
The Story of Fiscal Policy
 Individuals,
as individuals, are often not
prepared to increase their spending
during a recession.
 Collective action may be needed.
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11 - 7
The Story of Fiscal Policy
 With
fiscal policy, government could
provide the needed increased spending
by decreasing taxes, increasing
government spending, or both.
 The multiplier would then take over and
expand the effect of the initial spending.
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11 - 8
Aggregate Demand
Management
 Aggregate
demand management is
government's attempt to control the
aggregate level of spending in the
economy.
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11 - 9
Aggregate Demand
Management
 Demand
management is necessary
because the effects are significantly
different when one person does
something rather than everyone doing
the same thing.
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11 - 10
Aggregate Demand
Management
 Keynesians
argued that, in times of
recession, spending is a public good
that benefits everyone.
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11 - 11
Fighting Recession:
Expansionary Fiscal Policy
 The
economy is below potential income
during a recession.
 There is a recessionary gap.

Recessionary gap – the difference between
equilibrium income and potential income
when potential income exceeds
equilibrium income.
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11 - 12
Fighting Recession:
Expansionary Fiscal Policy
 Fighting
recession requires
expansionary fiscal policy.
 Assuming that government knows the
value of the multiplier, the right amount
of money could be injected into the
economy.
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11 - 13
Fighting Recession :
Expansionary Fiscal Policy
 When
multiplied, the increase in
aggregate demand closes the
recessionary gap.
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11 - 14
Fighting a Recession, Fig. 11-1, p 263
LRAS
Price Level
Initial AE
increase
$60
$120
AD0 AD1
$180
0
$1,000
Multiplier
effect
SAS
AD’1
$1,180 Real income
Real aggregate expenditures
LRAS
0
E2
AE1
AE0
G = $60
AE = 333 + 0.67Y
mpc = 0.67
E1
Recessionary
gap = $180
$1,000
$1,180 Real income
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11 - 15
Fighting Inflation:
Contractionary Fiscal Policy
 When
inflation begins to accelerate
beyond potential output, fiscal policy
works in reverse by decreasing
expenditures that are too high.
 Fighting inflation requires contractionary
fiscal policy.
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11 - 16
Fighting Inflation:
Contractionary Fiscal Policy
 If
the quantity of aggregate demand
exceeds potential income at that price
level, there will be excess demand and
pressures for inflation.
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11 - 17
Fighting Inflation:
Contractionary Fiscal Policy
 Output
may temporarily exceed
potential output because firms and
workers may be slow to raise prices and
wages.
 Soon shortages and accelerating
inflation will drive the economy back to
its potential income.
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11 - 18
Fighting Inflation:
Contractionary Fiscal Policy
 Government
should decrease its
expenditures by an amount that reflects
the magnitude of the multiplier.
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11 - 19
Fighting Inflation:
Contractionary Fiscal Policy
 This
expenditure reduction would
remove the inflationary gap.

Inflationary gap – the difference between
equilibrium income and potential income
when equilibrium income exceeds
potential income.
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11 - 20
LRAS
Price Level
P2
B
P1
A
P0
AD1
SAS1
SAS0
AD0
Real aggregate expenditures
Fighting Inflation, Fig. 11-2, p 264
$4,000 $4,700 $5,000 Real income
LRAS
E1
AE0
AE1
G = $200
AE = 800 + 0.8Y
mpc = 0.8
E2
Inflationary
gap = $1,000
$ 4,000
$ 5,000 Real income
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11 - 21
The Questionable
Effectiveness of Fiscal Policy
 There
are two ways to think about the
effectiveness of fiscal policy – in the
model and in reality.
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11 - 22
The Questionable
Effectiveness of Fiscal Policy
 The
effectiveness of fiscal policy in
reality depends on the government's
ability to perceive a problem, and react
appropriately to it.
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11 - 23
The Questionable
Effectiveness of Fiscal Policy
 If
the model is correct in describing the
economy, and if government acts
quickly enough in a countercyclical way,
depressions can be avoided.
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11 - 24
The Questionable
Effectiveness of Fiscal Policy
 A countercyclical
fiscal policy is one
in which the government offsets any
shock that would create a business
cycle.
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11 - 25
The Questionable
Effectiveness of Fiscal Policy
 Fine
tuning is the term used to describe
a fiscal policy designed to keep the
economy always at its target or potential
level of income.
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11 - 26
The Questionable
Effectiveness of Fiscal Policy
 All
economists now recognize that the
dynamic adjustment in the economy is
extraordinarily complicated, especially
when taking into account reasonable
expectations of future policy.
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11 - 27
Alternatives to Fiscal Policy
 Changes
in autonomous C, I, G, X, or
IM can achieve the same results as
fiscal policy.
 Changes in any of the five can achieve
the same results as fiscal policy.
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11 - 28
Alternatives to Fiscal Policy
 Any
policy that can change autonomous
expenditures without having offsetting
effects on other expenditures can be
used to influence the direction and
movement of aggregate income.
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11 - 29
Alternatives to Fiscal Policy
 There
are three alternatives to fiscal
policy:
Directed investment policies.
 Trade policies.
 Autonomous consumption policies.

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11 - 30
Directed Investment Policies:
Policy Affecting Expectations
 Directed
investment policies are
those affecting expectations to increase
investment.
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11 - 31
Directed Investment Policies:
Policy Affecting Expectations
 A numerical
example:
By how much must autonomous
investment increase, if income is $400 less
than desired and the mpc is 0.5?
 Working backward, the multiplier is 2, so
autonomous investment must increase by
$200.

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11 - 32
Directed Investment Policies:
Policy Affecting Expectations
 Directed
investment policies include
rosy scenario policies and financial
guarantees.
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11 - 33
Rosy Scenario
 Rosy
scenario policies involve talking
the economy well.
 Almost invariably, government officials
paint optimistic pictures as to where the
economy is headed.
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11 - 34
Rosy Scenario
 These
have been called rosy scenario
policies—government policies of
making optimistic predictions and never
making gloomy predictions.
 Upbeat predications must be credible
for rosy scenario policies to work.
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11 - 35
Financial Guarantees
 Another
way to influence investment is
to protect the financial system by
government guarantees or promises of
guarantees.
 An example would be a government
policy preventing bank failures.
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11 - 36
Financial Guarantees
 Still
another way in which government
can influence investment is through
influencing the interest rate.
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11 - 37
Trade Policy and Export-Led
Growth
 Any
governmental policy that increases
autonomous exports and decreases
autonomous imports will also have
multiplied effects on income.
 These policies are called export-led
growth policies.
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11 - 38
Trade Policy and Export-Led
Growth
growth policies – designed
to stimulate exports and increase
aggregate expenditures on Canadian
produced goods.
 Export-led
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11 - 39
Trade Policy and Export-Led
Growth
 Alternatively,
any policy that will lower
imports, such as increasing tariffs, will
have the same expansionary effect on
income.
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11 - 40
Trade Policy and Export-Led
Growth
 A numerical
example:
By how much must net exports increase, if
income is $300 less than desired and the
mpc is 0.33?
 Working backward, the multiplier is 1.5, so
net exports must increase by $200.

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11 - 41
The Global Economy Is
Interdependent
 If
one nation follows an export-led
growth policy, it forces other nations into
an import-led decline for its economy.
 It can reasonably be expected that other
nations will retaliate against an exportled growth policy.
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11 - 42
The Global Economy Is
Interdependent
 As
a consequence, many economists
support free trade agreements such as
NAFTA (North American Free Trade
Agreement).
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11 - 43
Exchange Rate Policies
 The
trade balance can also be affected
through exchange rate policy.
 An exchange rate policy deliberately
affects a nation’s exchange rate in order
to affect its trade balance.
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11 - 44
Exchange Rate Policies
 A low
value of a country's currency
relative to currencies of other countries
encourages exports and discourages
imports.
 A high value of a country's currency
relative to currencies of other countries
discourages exports and encourages
imports.
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11 - 45
Autonomous Consumption
Policy
 Autonomous
consumption policy is a
third alternative.
 Increasing the availability of consumer
credit to individuals increases
consumption.
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11 - 46
Real World Examples
 The
effect of wartime spending in the
1930s and 1940s and the prolonged
expansion of the mid-1990s to early
2000s illustrate how fiscal and other
expenditure policies work.
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11 - 47
Fiscal Policy in World War II
 Taxes
rose during World War II, but
government expenditures rose much
more.
 The deficit shot up and real income rose
by more than the increase in the deficit.
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11 - 48
Fiscal Policy in World War II
 But
where is the price-level increase
one would expect?
 One would normally expect a huge
inflation.
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11 - 49
Fiscal Policy in World War II
 The
wartime expansion was
accompanied by wage and price
controls and rationing.
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11 - 50
Fiscal Policy in World War II
 Owing
to the death of soldiers and
sailors, unemployment was
unintentionally reduced.
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11 - 51
War Finance:
Expansionary Fiscal Policy, Fig.
11-3a, p 270
Year
GNP (billions of 1971
dollars)
Federal deficit
(millions of dollars)
Unemployment rate
1937
16.4
17
9.0
1938
16.6
51
11.4
1939
17.8
119
11.4
1940
20.3
378
9.2
1941
23.2
396
4.4
1942
27.5
2137
3.0
1943
28.6
2557
1.7
1944
29.8
2559
1.4
1945
29.1
2123
1.6
1946
28.3
374
2.6
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11 - 52
War Finance:
Expansionary Fiscal Policy, Fig.
11-3b, p 270
Price
level
LRAS
AD0
0
$16.4
$30
AD1
Real output
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11 - 53
Recent Fiscal Policy
 The
deficit picture in the 1990s changed
from a large deficit to a large surplus.
 Economic theory would predict a slow
down in the economy – but the
economy boomed in the mid-1990s.
 There are two explanations for this
seeming paradox.
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11 - 54
Recent Fiscal Policy
 The
contractionary effect of the surplus
was offset by booms in consumer and
investment spending.
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11 - 55
Recent Fiscal Policy
 Much
of the surplus resulted from the
booming economy, not from
discretionary fiscal policy.
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11 - 56
Recent Fiscal Policy
 Much
of the deficit reduction and
movement into budget surplus resulted
from an increase in income.
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11 - 57
Recent Fiscal Policy
 The
economy exceeded economists'
estimate of potential income, without
generating inflation, by far more than
anyone thought.
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11 - 58
Problems with Fiscal and
Other Activist Policies
 Activist
government policy seems so
simple:
If the economy contracts, the government
runs an expansionary fiscal policy.
 If there's inflation, the government runs a
contractionary fiscal policy.

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11 - 59
Problems with Fiscal and
Other Activist Policies
 In
real life, that is not the way it is.
 That does not necessarily mean the
model is wrong.
 The model must be modified for it to
work in the real world.
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11 - 60
Problems with Fiscal and
Other Activist Policies
 The
model makes the following
assumptions:
Financing the deficit doesn't have
offsetting effects.
 The government knows what the situation
is.
 The government knows the level of
potential income.

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11 - 61
Problems with Fiscal and
Other Activist Policies
 The
model makes the following
assumptions:
The government has flexibility in changing
taxes and spending.
 Size of the government debt doesn't matter.
 Fiscal policy doesn't negatively affect other
government goals.

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11 - 62
Financing the Deficit Doesn't
Have Offsetting Effects
 Some
economists argue that
government financing of deficit
spending will offset the deficit's
expansionary effect.
 They object to the multiplier model
assumption that savings and investment
are unequal.
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11 - 63
Financing the Deficit Doesn’t
Have Offsetting Effects
 These
economists believe that the
interest rate equilibrates savings and
investment, and that government
borrowing increases interest rates and
crowds out private investment.
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11 - 64
Financing the Deficit Doesn’t
Have Offsetting Effects
 Crowding
out is the offsetting of a
change in government expenditures by
a change in private expenditures in the
opposite direction.
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11 - 65
Financing the Deficit Doesn’t
Have Offsetting Effects
 Crowding
out occurs because increased
government borrowing pushes up
interest rates in the economy.
 Private businesses have to borrow
when interest rates are high, so they
reduce their borrowing and investment.
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11 - 66
Financing the Deficit Doesn’t
Have Offsetting Effects
 The
expansionary effect of increased
government spending is reduced by
“crowding out” the private investment.
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11 - 67
Financing the Deficit Doesn’t
Have Offsetting Effects
 Some
economists argue that the effect
of government expenditures is negative,
because they consider private spending
to be more productive than government
spending.
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11 - 68
Financing the Deficit Doesn’t
Have Offsetting Effects
 Crowding
out also works in reverse in
contractionary fiscal policy.
 If the government is running a surplus
and buys back bonds, interest rates will
decline, stimulating investment, thereby
causing inflation.
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11 - 69
Financing the Deficit Doesn’t
Have Offsetting Effects
 Some
Keynesians argue that often the
crowding out will be offset by crowding
in.
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11 - 70
Crowding Out and Partial
Crowding Out, Fig. 11-4, p 273
Price level
Partial
crowding out
Aggregate expenditures
AP
SAS
AD0
Y0
AD2 AD1
Y2 Y1
AE1 (C + I0 +G1)
AE2 (C + I1 +G1)
(I1 – I0)
AE0 (C + I0 +G0)
G
Net effect =
Y2 – Y0
Y0
Y2 Y1
Partial
crowding out
Real output
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11 - 71
Knowing What the Situation
Is
 Getting
reliable numbers on the
economy takes time.
 We may even be in the middle of a
recession and not know it.
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11 - 72
Knowing What the Situation
Is
 The
government has large econometric
models and leading indicators to predict
where the economy will be in the near
future.
 Economic forecasting is still very much
an art and not a science.
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11 - 73
Knowing the Level of
Potential Income
 No
one knows for sure the level of
potential income.
 Potential income has been called the
full-employment level of income.
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11 - 74
Knowing the Level of
Potential Income
 Differences
in estimates of potential
income often lead to different policy
recommendations.
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11 - 75
Knowing the Level of
Potential Income
 Okun’s
law is general rule of thumb
economists use to translate changes in
the unemployment rate into changes in
income.
 According to Okun’s law a 1% fall in the
unemployment rate is associated with a
2% increase in income.
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11 - 76
Knowing the Level of
Potential Income
 In
most cases, the economy is in an
ambiguous state where some
economists are calling for expansionary
policy and others are calling for
contractionary policy.
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11 - 77
The Government’s Flexibility
in Changing Taxes and
Spending
 Even
if all economists agree that an
expansionary policy is needed, putting
fiscal policy into place takes time and
has serious implementation problems.
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11 - 78
The Government’s Flexibility
in Changing Taxes and
Spending
 Numerous
political and institutional
realities in Canada today make it a
difficult task to implement fiscal policy.
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11 - 79
The Government’s Flexibility
in Changing Taxes and
Spending
 Squabbles
between the Commons and
the Senate may delay implementing
appropriate fiscal policy for months,
even years.
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11 - 80
Size of the Government Debt
Doesn’t Matter
 These
is no inherent reason why the
adoption of activist policies should have
caused high government deficits year
after year.
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11 - 81
Size of the Government Debt
Doesn’t Matter
 Activist
policy has led to an increase in
government debt because:
Early activists favored large increases in
government spending as well as favoring
the government's using fiscal policy.
 Politically, it is much easier for government
to increase spending and decrease taxes
than vice versa.

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11 - 82
Size of the Government Debt
Doesn’t Matter
 If
one believes that debt is harmful, then
there might be a reason not to conduct
expansionary fiscal policy, even when
the model calls for it.
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11 - 83
Fiscal Policy Doesn’t
Negatively Affect Other
Government Goals
 An
economy has many goals; achieving
potential income is only one of those
goals
 National economic goals often conflict.
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11 - 84
Summary of the Problems
 While
the six problems listed above do
not necessarily eliminate fiscal policy
altogether, they severely restrict it.
 Fiscal policy is a sledgehammer, not an
instrument for fine-tuning.
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11 - 85
Fiscal Policy When the Price
Level is Flexible
 With
flexible prices, the short run supply
curve is upward sloping.
 A change
in government spending will
shift the aggregate demand, and
therefore, both income and prices will
be affected.
 Change in the price level will affect the
aggregate expenditure.
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11 - 86
Fiscal Policy When the Price
Level is Flexible
 If
price level increases, the aggregate
expenditure will be reduced.
 If prices fall, aggregate spending will
further increase.
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Eliminating a Recessionary
Gap When Prices are
Flexible, Fig. 11-5, p 278
LRAS
11 - 87
AP
AE1(P0 )
SAS
AE1(P1 )
P1
30
P0
AE0(P0 )
G=90
AD0
AD1
1000
Real output (Y)
1180
Real output (Y)
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11 - 88
Eliminating a Inflationary Gap
When Prices are Flexible, Fig. 11-6, p
279
LRAS
AP
SAS
P0
P1
AE0(P0 )
A
AE1(P1 )
A
B
B
250
AD0
AE1(P0 )
50
AD1
Real output (Y)
4000
5000
Real output (Y)
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11 - 89
Building Fiscal Policies Into
Institutions
 Economists
were quick to realize the
political realities of fiscal policy so they
attempted to create built-in fiscal
policies.
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11 - 90
Building Fiscal Policies Into
Institutions
 These
built-in fiscal policies are called
automatic stabilizers.
 Automatic stabilizers are any
government program or policy that
counteracts the business cycle without
any new government action.
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11 - 91
Building Fiscal Policies Into
Institutions
 Automatic
stabilizers include welfare
payments, unemployment insurance,
and the income tax system.
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11 - 92
Building Fiscal Policies Into
Institutions
 Automatic
stabilizers have their
problems:

When the economy first starts climbing out
of a recession, automatic stabilizers may
slow down the process.
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11 - 93
Building Fiscal Policies Into
Institutions
 Automatic
stabilizers have their
problems:

As income increases, automatic stabilizers
increase government taxes and decrease
government spending, and as they do, the
discretionary policy's expansionary effects
are decreased.
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11 - 94
Building Fiscal Policies Into
Institutions
 Despite
these problems, most
economists believe automatic stabilizers
have played an important role in
reducing fluctuations in the economy.
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11 - 95
Decrease in Fluctuations in
the Economy, Fig. 11-7, p 280
Pre-Keynesian regime
Keynesian regime
Modern
regime
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Demand Management
Policy : The Fiscal
Approach
End of Chapter 11
© 2003 McGraw-Hill Ryerson Limited.