Preface :

we have some problems in the economic system : recession

& inflation so we need the government internal in the
market to solve those kind of problems .

The government have 2 policies : monetary policy & fiscal

policy .

Revision on monetary policy :

monetary policy meaning that the government interval the
market by 2 ways : money supply & interest rate .

When we have a recession : meaning that the real GDP is

less than potential GDP , so the government will decrease
the interest rate & as a result ..
D = C + I + G + NX
Shifting the demand curve to the right until it reach the
equilibrium point to eliminate the recession gap .

When we have an inflation : meaning that the real GDP is

more than potential GDP , so the government will increase
the interest rate & as a result ..
D = C + I + G + NX
Shifting the demand curve to the left until it reach the
equilibrium point to eliminate the inflation gap .

Now the government have another option to eliminate

recession or inflation .. To use Fiscal Policy which it has 2
tools : 1) Government purchases or expenditure : It is a
part of The Aggregate Demand , so when G increase The
AD increase ! & vice versa

2) Cut Taxes : - when we have inflation the government

will increase the taxes and in this way the disposable
income decrease , according to ..
Yd = Y - T (- relation between Yd & T )
so the consumption decrease shifting the AD to the
left .

- when we have recession the government will decrease

taxes and in this way the disposable income increase so
the consumption increase shifting the AD to the right .

(:

Chapter 6
Fiscal policy
What is Fiscal Policy?
What Fiscal Policy Is and What It Isnt

Fiscal policy : Changes in federal taxes and purchases that

are intended to achieve macroeconomic policy objectives.
!

Automatic Stabilizers versus Discretionary Fiscal Policy :

Automatic stabilizers Government spending and taxes
that automatically increase or decrease along with the
business cycle.

The Effects of Fiscal Policy on Real GDP and the Price

Level
Expansionary and Contractionary Fiscal Policy

Expansionary Fiscal Policy

The previous graph shows that : the economy begins in

recession at point A, with real GDP of $14.2 trillion and a
price level of 98. An expansionary fiscal policy will cause
aggregate demand to shift to the right, from AD1 to AD2,
increasing real GDP from $14.2 trillion to $14.4 trillion and
the price level from 98 to 100 (point B).

Real GDP < potential GDP

5


To eliminate recession , T or G shift the AD curve to
the right until it reach the equilibrium point .
Contractionary Fiscal Policy

The previous graph shows that : the economy begins at

point A, with real GDP at $14.6 trillion and the price level
at 102. Because real GDP is greater than potential GDP,
the economy will experience rising wages and prices. A
contractionary fiscal policy will cause aggregate demand
to shift to the left, from AD1 to AD2, decreasing real GDP
from $14.6 trillion to $14.4 trillion and the price level
from 102 to 100 (point B).


Real GDP > potential GDP


To eliminate inflation , T or G shift the AD curve to
the left until it reach the equilibrium point .

A Summary of How Fiscal Policy Affects Aggregate

Demand

The Government Purchases and Tax Multipliers

Multiplier effect : The series of induced increases in

consumption spending that results from an initial increase
in autonomous expenditures.
!
.. 100 .. 100
7

 .. 80 .. 20 80
60 .. 20 60 .. 80
40 .. 20 40 .. 60 ..
.. 20 20 40
So the total output = 100 + 80 + 60 + 40 + 20 = 300
So the multiplier = Y = 3
G

Note that : the $100 is called the transfered amount

of money by the government to the house hold .
The Multiplier Effect and Aggregate Demand

The previous graph shows that : An initial increase in

government purchases of $100 billion causes the
aggregate demand curve to shift to the right, from AD1 to

the dotted AD curve, and represents the impact of the

initial increase of $100 billion in government purchases.
Because this initial increase raises incomes and leads to
further increases in consumption spending, the aggregate
demand curve will ultimately shift further to the right, to
AD2.
100
Shift AD curve to the right & increasing in output
! 100
5 100
500
Shift the AD curve to the right again !

The Multiplier Effect of an Increase in Government

Purchases

The previous graph shows that : Following an initial

increase in government purchases, spending and real GDP
increase over a number of periods due to the multiplier
effect.

10

The new spending and increased real GDP in each period is

shown in green, and the level of spending from the
previous period is shown in orange.
The sum of the orange and green areas represents the
cumulative increase in spending and real GDP. In total,
equilibrium real GDP will increase by $200 billion as a
result of an initial increase of $100 billion in government
purchases.

6 1
..

11

The ratio of the change in equilibrium real GDP to the

initial change in government purchases is known as the
government purchases multiplier:

The expression for the tax multiplier is:

The Effect of Changes in Tax Rates

A cut in tax rates affects equilibrium real GDP through
two channels:
A cut in tax rates increases the disposable income of
households, which leads them to increase their
consumption spending, and
a cut in tax rates increases the size of the multiplier
effect.
..
3
..

12

Taking into Account the Effects of Aggregate Supply

The Multiplier Effect and Aggregate Supply

The previous graph shows that : The economy is initially at

point A.
An increase in government purchases causes the
aggregate demand curve to shift to the right, from AD1 to
the dotted AD curve.
The multiplier effect results in the aggregate demand
curve shifting further to the right, to AD2 (point B).
Because of the upward-sloping supply curve, the shift in
aggregate demand results in a higher price level. In the
new equilibrium at point C, both real GDP and the price

13

level have increased. The increase in real GDP is less than

indicated by the multiplier effect with a constant price
level.

Appendix
A Closer Look at the Multiplier
An Expression for Equilibrium Real GDP

The letters with bars represent fixed or autonomous

values that do not depend on the values of other variables.
So,

represents autonomous consumption, which had a

value of 1,000 in our original example. Now, solving for

equilibrium
we get:

14

A Formula for the Government Purchases Multiplier

15

A Formula for the Tax Multiplier

:
= 4
= 5

1
1 0.8

1
1 MPC

0.8
1 0.8

MPC
1 MPC

= Tax multiplier

= Government Purchases Multiplier

16