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Slides By

David Gillette and Kevin Brady

Fiscal Policy and the Multiplier

Material from this presentation can be found in:

Chapter 19Chapter 20

Interactive Examples

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Fiscal Policy and the Multiplier

Price Level

(P)

Aggregate Output (Q)

SRAS

LRAS

Qf

Pe

AD

An economy is in long-run equilibrium when the aggregate demand curve (AD), short-run aggregate supply curve (SRAS), and long-run aggregate supply curve (LRAS) intersect at the same price level and output level.

Question 1:

Suppose consumers suddenly cut back on spending. What happens in the economy?

Answer

Interactive Examples

Fiscal Policy and the Multiplier

Price Level

(P)

Aggregate Output (Q)

SRAS

LRAS

Qf

Pe

AD

Question 1:

Suppose consumers suddenly cut back on spending. What happens in the economy?

Answer to Question 1:

P1

Q1

When consumers reduce spending, the AD curve shifts down and to the left.

This results in a short-run equilibrium at a lower output level (Q1) and a lower price level (P1).

Next

Interactive Examples

Fiscal Policy and the Multiplier

Price Level

(P)

Aggregate Output (Q)

SRAS

LRAS

Qf

Pe

AD

Question 2:

Suppose a new discovery of raw materials lowers input prices throughout the economy. What happens in the economy?

Answer

Interactive Examples

Fiscal Policy and the Multiplier

Price Level

(P)

Aggregate Output (Q)

SRAS

LRAS

Qf

Pe

AD

Question 2:

Suppose a new discovery of raw materials lowers input prices throughout the economy. What happens in the economy?

Answer to Question 2:

P1

Q1

When input prices decline, the SRAS curve shifts down and to the right.

This results in a short-run equilibrium at a higher output level (Q1) and a lower price level (P1).

Next

Interactive Examples

Fiscal Policy and the Multiplier

Price Level

(P)

Aggregate Output (Q)

SRAS

LRAS

Q1

P1

AD

In the previous two examples, the economy started at long-run equilibrium. Let’s examine a situation where the economy is below its long-run equilibrium output level, at Q1.

Question 3:

The government realizes the economy is operating below equilibrium and decides to implement a stimulus package that includes spending on infrastructure. What effect will this have on our model?

Pe

Qf

Answer

Interactive Examples

Fiscal Policy and the Multiplier

Price Level

(P)

Aggregate Output (Q)

SRAS

LRAS

Qf

Pe

AD

In the previous two examples, the economy started at long-run equilibrium. Let’s examine a situation where the economy is below its long-run equilibrium output level.

Question 3:

The government realizes the economy is operating below equilibrium and decides to implement a stimulus package that includes spending on infrastructure. What effect will this have on our model?

Answer to Question 3:

When the government spends, the AD curve shifts up and to the right.

In this graph, the result is a return to the long-run equilibrium at Qf and Pe.

Next

Interactive Examples

P1

Q1

Fiscal Policy and the Multiplier

Price Level

(P)

Aggregate Output (Q)

SRAS

LRAS

Q1

P1

AD

In the previous three examples, we looked at the short-run implications of various shocks and government policies. Let’s examine what happens in the long run.

The graph to the right shows our economy operating below the long-run equilibrium. Let’s assume we are $1 billion below equilibrium output at Q1, the spending multiplier is 2, and Congress passes a $1 billion dollar stimulus package.

Question 4:

What would happen in our model?Pe

Qf

Answer

Interactive Examples

Fiscal Policy and the Multiplier

Price Level

(P)

Aggregate Output (Q)

SRAS

LRAS

Qf

Pe

AD

Answer to Question 4:

Despite the government’s good intentions, they failed to take into account the effect of the spending multiplier, and so the AD curve shifts past the point where long-run equilibrium would have been, all the way to Q2 and P2.

The higher level of output is only temporary, however, as workers and suppliers adjust their expectations to the higher price level of P2. This causes the SRAS curve to shift up and to the left. Prices rise further until workers adjust their inflationary expectations and a new long-run equilibrium is reached at Qf and P3.

Interactive Examples

P1

Q1

In the previous three examples, we looked at the short-run implications of various shocks and government policies. Let’s examine what happens in the long-run.

The graph to the right shows our economy operating below the long-run equilibrium. Let’s assume we are $1 billion below equilibrium output at Q1, the spending multiplier is 2, and Congress passes a $1 billion dollar stimulus package.

Question 4:

What would happen in our model?

P3

P2

Q2

The End