Staticvs.DynamicModelOur model of fiscal policy so far is static: it assumes long-run potentialGDP does not change, and that the price level is constant.Whilethelessonsfromthismodel are stillappropriate-Congressand the president can use fiscal policy to affect real GDP and theprice levelour understanding of fiscal policy can be improved byseeing it in the dynamic aggregate demand and aggregate supplymodel.@2015PearsonEducation,Inc.16
© 2015 Pearson Education, Inc. 16 Static vs. Dynamic Model Our model of fiscal policy so far is static: it assumes long-run potential GDP does not change, and that the price level is constant. While the lessons from this model are still appropriate—Congress and the president can use fiscal policy to affect real GDP and the price level—our understanding of fiscal policy can be improved by seeing it in the dynamic aggregate demand and aggregate supply model
Expansionary Fiscal Policy inthe Dynamic AD-AS ModelInitially, the economy is inlong-run equilibrium.ThefederalgovernmentLRAS,LRAS2Price levelIncrease inADdue toprojects that aggregate(GDPdeflator,expansionaryfiscal policy2009=100)demand will not rise bySRAS!enough to maintain fullSRAS2115employment.113It enacts an expansionary110fiscal policyto increaseAD2(with policy)AD2(without policy)aggregate demand,hopefully to the fullAD,employment level.$17.0RealGDP017.317.4Thepricelevelishigher(trillions of 2009dollars)thanitwouldhavebeenFigure 16.6Anexpansionaryfiscalwithouttheexpansionarypolicy in the dynamic modelfiscalpolicy.7@2015PearsonEducafion,lnc
© 2015 Pearson Education, Inc. 17 Expansionary Fiscal Policy in the Dynamic AD-AS Model Initially, the economy is in long-run equilibrium. • The federal government projects that aggregate demand will not rise by enough to maintain full employment. • It enacts an expansionary fiscal policy to increase aggregate demand, hopefully to the full employment level. The price level is higher than it would have been without the expansionary fiscal policy. An expansionary fiscal policy in the dynamic model Figure 16.6
Contractionary Fiscal Policy in the Dynamic AD-AS ModelTheeconomystartsoncemore in long-run equilibriumDecrease inAD dueto.The federal governmentcontractionaryfiscalpolicyprojects that aggregatePrice levelLRAS,LRAS2SRAS,(GDPdeflator)SRAS2demandwill rise so2009=100)much that employment115is beyond the full-113employment level,110AD2(without policy)causing high inflation.AD2(with policy)Itenactsacontractionaryfiscal policyto decreaseAD,aggregate demand, again$17.017.4 17.5RealGDP(trillions of 2009dollars)ideally to the fullemployment level.Figure 16.7Acontractionaryfiscalpolicy in the dynamic model18@2015Pearson Education,Inc
© 2015 Pearson Education, Inc. 18 Contractionary Fiscal Policy in the Dynamic AD-AS Model The economy starts once more in long-run equilibrium. • The federal government projects that aggregate demand will rise so much that employment is beyond the fullemployment level, causing high inflation. • It enacts a contractionary fiscal policy to decrease aggregate demand, again ideally to the full employment level. A contractionary fiscal policy in the dynamic model Figure 16.7
TheGovernment PurchasesandTaxMultipliers16.4LEARNINGOBJECTIVEExplainhowthegovernmentpurchasesandtaxmultiplierswork19@2015PearsonEducafion,lnc
LEARNING OBJECTIVE © 2015 Pearson Education, Inc. 19 The Government Purchases and Tax Multipliers 16.4 Explain how the government purchases and tax multipliers work
AggregateDemandandtheMultiplierEffectPrice levelIf the government(GDPdeflator,2...andthe2005=100)increasesitsmultipliereffectresultsinafurtherspending on goodsshift.and services, thenaggregatedemand100increases1.Aninitials100immediately. ThisbillionincreaseinFigure 16.8govemmentistheautonomouspurchasesshiftstheaggregateThe multiplierincrease indemandcurvetoeffectandADAD,AD2therightby$100billion...aggregateaggregatedemanddemand.0Real GDP(trillionsofBut then people receive this increased spending as increased ins)and increase their consumption spending accordinglyThis isthe induced increase in aggregate demand.:The series of induced increases in consumption spending thatresults from the initialincreasein autonomous expenditures isknown as the multiplier effect.20@2015PearsonEducation,Inc
© 2015 Pearson Education, Inc. 20 Aggregate Demand and the Multiplier Effect If the government increases its spending on goods and services, then aggregate demand increases immediately. This is the autonomous increase in aggregate demand. But then people receive this increased spending as increased income and increase their consumption spending accordingly. This is the induced increase in aggregate demand. • The series of induced increases in consumption spending that results from the initial increase in autonomous expenditures is known as the multiplier effect. The multiplier effect and aggregate demand Figure 16.8