21.2 How Fiscal Policy Influences Aggregate Demand
21.2 a. Changes in Government Purchases
Since government spending is one of the components of aggregate demand, an increase in government spending will shift the demand curve to the right [11].
Example: In times of economic boom, Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices when inflation is too high [11].
Fiscal Policy [12]
21.2 b. The Multiplier Effect
A change in fiscal policy has a multiplier effect on the economy because fiscal policy affects spending, consumption and investment levels in the economy. The multiplier effect is the amount that additional government spending affects income levels in the country [13].
Example: The recipients of increased government contracts or government salaries increase their consumption demand, and the recipients of this increased purchasing power are in turn able to increase their demand of goods and services and so on [14].
Multiplier Effect [15]
21.2 c. A Formula for the Spending Multiplier
The marginal propensity to consume (MPC) is equal to ΔC / ΔY, where ΔC is change in consumption, and ΔY is change in income. The expenditure multiplier is the ratio of the change in total output induced by an autonomous expenditure change [16].
Example: suppose a large corporation decides to build a factory in a small town and that spending on the factory for the first year is $5 million. That $5 million will go to electricians, engineers and other various people building the factory. If MPC is equal to 0.8, those people will spend $4 million on various goods and services. The various business and individual receiving that $4 million will in turn spend $3.2 million and so on [16].
If the marginal propensity to consume is equal to 0.8 (4 / 5), then the multiplier can be calculated as [16]:
Multiplier = 1 / (1 – MPC) = 1 / (1 – 0.8) = 1 / 0.2 = 5
Multiplier Effect [15]
21.2 d. The Crowding-Out Effect
The crowding out effect is an economic theory arguing that rising public sector spending drives down or even eliminates private sector spending [17].
Example: Suppose a firm has been planning a capital project that with an estimated cost of $5 million and return of $6 million, assuming the interest rate on its loans remains 3%. The firm anticipates earning $1 million in net income. Due to the shaky state of the economy, however, the government announces a stimulus package that will help businesses in need but will also raise the interest rate on the firm’s new loans to 4%. Because the interest rate the firm had factored into its accounting has increased by 33.3%, its profit model shifts wildly and the firm estimates that it will now need to spend $5.75 million on the project in order to make the same $6 million in returns. Its projected earnings have now dropped by 75% to $250,000, so the company decides that it would be better off pursuing other options [17].
Fiscal Policy and Crowding Out [20]
21.2 e. Changes in Taxes
Tax cuts for individuals will tend to increase consumption demand, while tax increases will tend to diminish it. Tax policy can also pump up investment demand by offering lower tax rates for companies or tax reductions that benefit specific kinds of investment. Shifting C (private consumption) or I (gross investment) will shift the AD curve as a whole [18].
Example: Beginning with President Ronald Reagan and the advent of supply-side economics in the 1980s, governments have increasingly toyed with tax cuts to change aggregate demand in part because they are more likely to have an immediate effect on consumer and business expectations and incentives [19].
Fiscal Policy [12]
