THE CAR ANALOGY
The economy is like a car
• You can drive 120mph but it is not sustainable
• Like extremely low unemployment
• You could drive a car at 20mph
• such at high unemployment
• But 70mph is sustainable and is what its designed for
• Such as full unemployment 4-6%
• The engine (technology) of gas milage (productivity)
How does the government stabilize the economy?
THe government has two different tools to use
0. Fiscal policy
1. Monetary policy
Fiscal policy is actions by congress to stabilize the economy
Monetary policy is actions by the federal reserve to stabilize the economy.
Two different types of fiscal policy
DISCRETIONARY FISCAL POLICY
• Congress creates a new bill that is designed to change Ad through government
spending or taxation
• Problem is time lags due to bureaucracy
• takes time for congress to act
• ex. In a recession congress increases spending
NON DISCRETIONARY FISCAL POLICY
• AKA. Automatic stabilizers
• Permanent spending taxation laws enacted to work counter cyclically to stabilize the
economy
• ex. Welfare, unemployment, min. wage etc.
• When there is high unemployment what are ways government can stimulate
economy?
CONTRACTIONARY FISCAL POLICY (THE BRAKE)
Laws that reduce inflation, decrease GDP
• Decrease government spending
• Tax increases
• Combinations of the two
EXPANSIONARY FISCAL POLICY (THE GAS)
LAWs that reduce unemployment and increase GDP (Close a recessionary Gap)
• Increased government spending
• decrease taxes on consumers
• combinations of the two
How much should the government spend?
THE MULTIPLIER EFFECT
Why do cities want the Superbowl in their stadium?
An initial change in spending will set off a spending chain that is magnified in the
economy.
Example?
Bobby spends $100 on Jason's product
• jason now has more income so he buys $100 of nancy's
• Nancy now has more income so she buys $100 of Tiffany's product
• The result is at least $300 increase in consumer spending
EFFECTS OF GOVERNMENT SPENDING
If the government spends $5million will AD increase by the same amount?
• No, AD will increase even more as spending becomes income for consumers.
• Consumers will take that money and spend thus increasing AD
How much will AD increase
• It depends on how much of the new income consumers save
• If they save a lot spending and AD will increase less
• If they save less, then spending and AD will increase a lot.
MARGINAL PROPENSITY TO CONSUME
Marginal Propensity to consume (MPC)
• How much people consumer rather than save
• It is always expressed as a fraction
MPC = Change in consumption
Change in income
MARGINAL PROPENSITY TO SAVE (MPS)
• How much people save rather then consume when there is a change in income
• It is also expressed as a fraction
MPS = Change in savings
Change in income
MPS = 1 - MPC
Why is this true?
Because people can either save or consume
HOW IS SPENDING MULTIPLIED?
Assume the MPC is .5 for everyone?
• Assume the Superbowl comes to town and there is an increase of $100 in ashley's
rester aunt
• Ashley now has $100 more income
• She now saves $50 and spends $50 at Karl's Salon
• Karl now has $50 more income
• $25 and spends $25 at Dans Fruit stand
• Dan now has $25 more income
• This continues until every penny is either saved or spend
**Total Change in GDP = multiplier x initial change in spending
CALCULATING THE SPENDING MULTIPLIER
If MPC is .5, how much is the multiplier?
spending multiplier
1
Or
1
MPS
1 - MPC
• if the multiplier is 4 how much will an initial increase of $5 in government spending
increase the GDP?
• How much will a decrease in $3 in spending decrease GDP?
Lets practice the spending multiplier
2. If MPC is .9 what is multiplier?
3. if MPC is .8 what is the multiplier?
4. If MPC is .5 and consumption increased $2 million, how much will GDP increase?
Conclusion: as the marginal propensity to consume falls, the multiplier effect is less.
WHAT ABOUT TAXING?
• The multiplier effect also applies when the government cuts or increases taxes
• But chaining taxes has less of an effect then government spending. Why?
EXPANSIONARY POLICY (CUTTING TAXES)
• Assume the MPC is .75 so the multiplier is 4 if the government cuts taxes by $4 million
how will consumer spending increase?
• When they get the tax cut, consumers will save $1 million and spending $3 million
• The $3 million amount will be magnified in the economy.
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