1Preface :

we have some problems in the economic system : recession& inflation so we need the government internal in themarket to solve those kind of problems .

The government have 2 policies : monetary policy & fiscalpolicy .

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

When we have a recession : meaning that the real GDP isless than potential GDP , so the government will decreasethe interest rate & as a result ..

D = C + I + G + NXShifting the demand curve to the right until it reach theequilibrium point to eliminate the recession gap .

2When we have an inflation : meaning that the real GDP ismore than potential GDP , so the government will increasethe interest rate & as a result ..

D = C + I + G + NXShifting the demand curve to the left until it reach theequilibrium point to eliminate the inflation gap .

Now the government have another option to eliminaterecession or inflation .. To use Fiscal Policy which it has 2tools : 1) Government purchases or expenditure : It is apart of The Aggregate Demand , so when G increase TheAD increase ! & vice versa2) Cut Taxes : - when we have inflation the governmentwill increase the taxes and in this way the disposableincome decrease , according to ..

Yd = Y - T (- relation between Yd & T )so the consumption decrease shifting the AD to theleft .

3- when we have recession the government will decreasetaxes and in this way the disposable income increase sothe consumption increase shifting the AD to the right .

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Chapter 6Fiscal policy

What is Fiscal Policy?What Fiscal Policy Is and What It Isnt

Fiscal policy : Changes in federal taxes and purchases thatare intended to achieve macroeconomic policy objectives.

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Automatic Stabilizers versus Discretionary Fiscal Policy :Automatic stabilizers Government spending and taxesthat automatically increase or decrease along with thebusiness cycle.

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5Expansionary Fiscal Policy

The previous graph shows that : the economy begins inrecession at point A, with real GDP of $14.2 trillion and aprice level of 98. An expansionary fiscal policy will causeaggregate demand to shift to the right, from AD1 to AD2,increasing real GDP from $14.2 trillion to $14.4 trillion andthe price level from 98 to 100 (point B).

Real GDP < potential GDP

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

7 Real GDP > potential GDP

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

A Summary of How Fiscal Policy Affects AggregateDemand

The Government Purchases and Tax MultipliersMultiplier effect : The series of induced increases inconsumption spending that results from an initial increasein autonomous expenditures.

! .. 100 .. 100

8 .. 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 = GY = 3Note 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 ingovernment purchases of $100 billion causes theaggregate demand curve to shift to the right, from AD1 to

9the dotted AD curve, and represents the impact of theinitial increase of $100 billion in government purchases.Because this initial increase raises incomes and leads tofurther increases in consumption spending, the aggregatedemand curve will ultimately shift further to the right, toAD2. 100 Shift AD curve to the right & increasing in output ! 100 5 100 500Shift the AD curve to the right again !

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The Multiplier Effect of an Increase in GovernmentPurchases

The previous graph shows that : Following an initialincrease in government purchases, spending and real GDPincrease over a number of periods due to the multipliereffect.

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The new spending and increased real GDP in each period isshown in green, and the level of spending from theprevious period is shown in orange.The sum of the orange and green areas represents thecumulative increase in spending and real GDP. In total,equilibrium real GDP will increase by $200 billion as aresult of an initial increase of $100 billion in governmentpurchases.

6 1 ..

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The ratio of the change in equilibrium real GDP to theinitial change in government purchases is known as thegovernment purchases multiplier:

The expression for the tax multiplier is:

The Effect of Changes in Tax RatesA cut in tax rates affects equilibrium real GDP throughtwo channels: A cut in tax rates increases the disposable income of

households, which leads them to increase theirconsumption spending, and a cut in tax rates increases the size of the multiplier

effect. .. 3 ..

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Taking into Account the Effects of Aggregate SupplyThe Multiplier Effect and Aggregate Supply

The previous graph shows that : The economy is initially atpoint A.An increase in government purchases causes theaggregate demand curve to shift to the right, from AD1 tothe dotted AD curve.The multiplier effect results in the aggregate demandcurve shifting further to the right, to AD2 (point B).Because of the upward-sloping supply curve, the shift inaggregate demand results in a higher price level. In thenew equilibrium at point C, both real GDP and the price

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level have increased. The increase in real GDP is less thanindicated by the multiplier effect with a constant pricelevel.

AppendixA Closer Look at the MultiplierAn Expression for Equilibrium Real GDP

The letters with bars represent fixed or autonomousvalues that do not depend on the values of other variables.So, represents autonomous consumption, which had avalue of 1,000 in our original example. Now, solving forequilibriumwe get:

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A Formula for the Government Purchases Multiplier

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