Question

Using the Multiplier Model, show graphically and explain how the aggregate demand function may shift with these fiscal policies. Please include an explanation of how the multiplier process will affect the results of the fiscal stimulus (think specifically over time) - using a numerical example assuming a marginal propensity to consume equal to 0.5 and a fiscal stimulus equal to 40 billion. According to the model, what is the multiplier and how much would the output increase by? Please include a list of examples of fiscal stimulus and how they affect the aggregate demand function.

Answer 1

So let's say economy is facing a recessionary gap of 80 billion. Actual GDP stands at 120billion while potential GDP is at 200 billion. To mitigate this gap an expansionary fiscal policy is planned to be impanted. So now we need to figure how big the stimulus will have to be to close this gap. For this we consider the multiplier given the mpc is 0.5. The multiplier is 1/0.5 =2. So based on the multiplier any amount of fiscal stimulus will double when the multiplier effect occurs. So to close a gap of 80 billion, a 40 billion fiscal stimulus will be used. At first the fiscal stimulus will increase spending by the amount of fiscal stimulus. This initial rise in spending will increase total output(income) levels. Based on the rise in incomes, consumption will increase in the next period based on the mpc. This will again increase total spending and output levels. When the multiplier effect has completed its affect, the AD will shift further - causing a rise in output by 80billion.

Numerically, first GDP increases by 40b due to fiscal stimulus in period 0. Due to this increase in output by 40b, consumption increases in period 1 by 0.5*40=20b. This raises output again by 20b. Again in period 2, consumption rises by 0.5*20=10b; in period 3 consumption rises by 0.5*10=5b; in period 4, consumption rises by 2.5b; in period 5, consumption rises by 1.25b; in period 6, it rises by 0.675b..This process will continue till 40b fiscal stimulus converts to total of 80b due to the total multiplier effect.

P ERAS SRAS 1 AD AD 120b zoob >Y

There are a few types of fiscal stimuluses - the basic kind is an increase in government purchases which increases output and in turn consumption and again output. Thus AD function increases (and shifts right).

Next in a decrease in tax rates/ increase in subsidies - Both increase disposable income and consequently consumption and again income. AD function expands.

Another fiscal stimulus can be rise in transfer payments. This has the same effect on AD as stated above.