Dr. Mohammed Alwosabi Econ141 – Ch.

Notes on Chapter 8
FISCAL POLICY

— Government Budget is the annual statement of government

expenditures and revenues (from tax and any other resources),
together with the laws and regulations that approve and support
these expenditures and revenues.
— The budget has two purposes:
1. To finance the activities of the government
2. To stabilize the economy (the fiscal policy)
— Government budget balance is the tax revenues and any other
revenues minus expenditures
— Government budget = All types of taxes (revenues) – government
expenditures – transfer payments – debt interests
o If tax revenue > expenditures, government has budget
surplus Ö government debt decreases. and government can
lend others
o If tax revenue < expenditures, government has budget
deficit Ögovernment debt increases and government needs
to borrow.
o If tax revenue = expenditures, government has budget
balance
— Fiscal policy is the use of government budget to achieve
macroeconomic objectives such as full employment, sustained
economic growth, and price level stability.
— Fiscal policy action that seek to stabilize the business cycle work by
changing aggregate demand.
— These policy actions can be either automatic or discretionary:

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Dr. Mohammed Alwosabi Econ141 – Ch. 8

o Automatic FP is a change in FP that is triggered by the state

of the economy. For example, an increase of workers’
income triggers an automatic increase in tax revenues. That
is this type of FP adjusts automatically.
o Discretionary FP is a policy action that is initiated by
government. For example if government passes a law that
increases or decreases taxes.
— Fiscal policy can be expansionary or contractionary.
— Expansionary fiscal policy occurs when the economy has less
than full employment RGDP and government wants to increase
RGDP and employment.
— In expansionary fiscal policy, the government increases its
spending (G) or cuts taxes (T) or both.
o When the government increases G, it adds directly to AD,
since G is part of AD
o When the government cuts T, it increases people's
disposable income (total income minus taxes), and people
will spend much of that extra income, so consumption (C)
increases.
o In both cases, AE (and AD) will also increase indirectly
through the multiplier effect, as the initial increase in G or C
touches off a whole chain of consumption. AE shifts upward
and AD shifts rightward. This will cause equilibrium RGDP
(Y) to increase and the equilibrium price level (P) to increase.
— Contractionary fiscal policy occurs when the government cuts its
spending (G) or raises taxes (T) or both.
— Contractionary fiscal policy, would cause AE to shift downward and
AD to shift leftward. As a result, equilibrium Y decreases and
equilibrium P decreases.

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Dr. Mohammed Alwosabi Econ141 – Ch. 8

FISCAL POLICY MULTIPLIERS

— To study the effects of discretionary changes in government
spending and taxes, we assume that:
1. There is no international trade (MPI = 0)
2. Taxes are all lump-sum. Lump-sum taxes are taxes that do not
vary with RGDP. The government fixes them, and they do not
change until government changes them. The main example of a
lump-sum tax is the property tax
3. Price level is fixed in the very short run

Government purchases multiplier

— The government purchases multiplier shows the magnitude effect
of changes in G on equilibrium aggregate expenditure and RGDP.
— G ↑ → AE ↑ and AD ↑ → AE curve shifts upward and AD curve
shifts rightward → RGDP ↑ → C ↑ → AE ↑ and this process
continue for multiples of times.
∆Y 1
— Government purchase multiplier = =
∆G 1 − MPC
— Example:
If MPC = 0.9, then the government purchase multiplier = 1/(1-0.9) =
1/0.1 = 10
— Example:
If G multiplier is 5 and if G increases by $30 million what would be
the amount of change in RGDP?
⎛ 1 ⎞
∆Y = m × ∆G = ⎜ ⎟ ∆G = 5 × 30 = $150 million
⎝ 1 − MPC ⎠
RGDP will increase by 150 million and AD curve will shift rightward

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Dr. Mohammed Alwosabi Econ141 – Ch. 8

Lump-sum tax multiplier

— The lump-sum tax multiplier shows the magnitude effect of changes
in lump-sum taxes on equilibrium aggregate expenditure and
RGDP.
— When the government cuts taxes, people spend their extra after-tax
income, and that initial increase in consumption leads to more
consumption, by the people who sell the goods or services in each
round of consumption. Again, because of the multiplier effect, the
ultimate increase in AE and Y (which is entirely an increase in C in
this case) will be a multiple of the original tax cut.
— When the government raises taxes, the opposite is true. T ↑ → Yd ↓
→ C ↓ → AE ↓ and AD↓ → AE shifts downward and AD shifts
downward → RGDP ↓.
∆Y − MPC
— Lump-sum tax multiplier = =
∆T 1 − MPC
— The multiplier is negative because higher taxes reduce people's
disposable income, thereby reducing their consumption.
— The tax multiplier is smaller (in absolute value) than the
government purchase multiplier because not all of a tax cut
represents income that otherwise would have been consumed.
Since the marginal propensity to consume is less than 1, some
fraction of the amount people get because of the tax cut will be
saved, which does not add to aggregate demand or GDP.
— Example:
If MPC = 0.9, then the tax multiplier = -0.9/(1-0.9) = -0.9/0.1 = -9
— Example:
If T multiplier is -4 and if T increases by $30 million, what would be
the amount of change in RGDP?
⎛ − MPC ⎞
∆Y = m × ∆T = ⎜ ⎟ ∆T = −4 × 30 = −$120 million
⎝ 1 − MPC ⎠

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Dr. Mohammed Alwosabi Econ141 – Ch. 8

RGDP will decrease by 120 million and AD curve will shift leftward
— Exercise:
Suppose an economy in the very short run with no relation with the
rest of the world and with MPC = 0.80. The government wants to
increase the country’s RGDP by $100 million.
a. How much government should raise its purchase in order to
achieve this goal?
b. How much tax cut government should make in order to
achieve this goal?

Discretionary Fiscal Stabilization

— In the figure below an increase in government purchases increases
aggregate demand.
— A multiplier effect increases aggregate demand further. Real GDP
increases and the price level rises.

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Dr. Mohammed Alwosabi Econ141 – Ch. 8

— PGDP is $10 trillion but RGDP is $9 trillion, and there is a 1 trillion

recessionary gap. An increase in G or a decrease in T increases
expenditure by UE. The multiplier increase induced expenditure.
The AD curve shifts rightward to AD1, P rises to 105, RGDP
increases to $10 trillion, and the recessionary gap eliminated.
— The opposite is rue. A decrease in government purchases
decreases aggregate demand. A multiplier effect decreases AD
further. RGDP decreases and the price level falls until the
inflationary gap eliminated.

FISCAL POLICY AND AD

AE
— To understand what happens to
45 0
AD, P, RGDP and employment
when FP changes let us study 800 AE1
B
AE0
the following example
400 AE2
— Initially, AE is AE0 and AD is AD0. A
Price level is constant at P = 110,
100 C
MPC = 0.75 and RGDP = $400
million, the economy is at point A.
RGDP
— Now suppose that government 100 400 800
P
spending increases by
100 (∆G = +100)
B
To know what the change in 110
C A
RGDP is, we calculate government
AD1
purchase multiplier AD2 AD0
∆Y 1 1 RGDP
m= = = =4 100 400 800
∆G 1 − MPC 1 − 0.75
∆Y = m. ∆G = 4 (100) = 400
New equilibrium RGDP = 400 + 400 = 800

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Dr. Mohammed Alwosabi Econ141 – Ch. 8

— Therefore, with constant P, RGDP increase to 800 at point B where

AE shifts to AE1 and intersects the 45º line and AD shifts to AD1.
The government purchase multiplier determines the distance by
which the AD curve shifts rightward. The larger the multiplier, the
larger is the shift in the AD curve resulting from a given change in
government purchase.
— Suppose tax increases by 100 million ( ∆T = +100)
The increase in tax shifts AE downward to AE2. The question is by
how much? That depends on tax multiplier. The lump-sum tax
multiplier is
∆Y − MPC − 0.75
m= = = = −3
∆T 1 − MPC 1 − 0.75
∆Y = m. ∆T = (-3) (100) = -300
New equilibrium = Y+ ∆Y = 400 -300 = +100
— So, Price level didn’t change but the quantity of RGDP demanded
decreases to 100 million. AD shifts leftward to AD2
— When government takes an expansionary FP (↑G or ↓T), AD curve
shifts rightward
— When government takes a contractionary FP (↓G or ↑T), AD curve
shifts leftward
— The distance of the Ad curve shift is smaller for changing tax than
for changing government purchase of the same size.

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Dr. Mohammed Alwosabi Econ141 – Ch. 8

SR and LR effects of FP
— Initially, the economy is at equilibrium point P
LAS SAS1
A, where AD, SAS and LAS intersect. P =
D
P0 and RGDP = Y0. P2
SAS0
C
— An increase in G shifts AD curve rightward
P1
from AD0 to AD1. P0 A B

— Very SR Effect AD1

P is constant at P0 while RGDP ↑ to Y1 at AD0

RGDP
Y0 Y2 Y1
point B
— SR Effect:
— During the adjustment process, the price level does not remain
constant. It gradually rises and the economy moves along SAS
curve to the point of intersection of SAS and AD curves (at point C)
where P↑ to P1 and Y↓ to Y2
— LR Effect:
At point C, RGDP exceeds PGDP and the economy is at above-full
employment equilibrium (unemployment is below the natural rate).
The money wage rate rises and SAS decreases. The SAS curve
shifts leftward to SAS1 and in LR the economy moves to point D
where P is P2 and Y is back at Y0
— The Conclusion: In the long run, FP multiplier is zero. The increase
in RGDP is only temporary but with permanent the rise in the price
level.