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Short Run
Fiscal Actions

Explore how government spending and taxation shift aggregate demand in the short run, close output gaps, and stabilize the economy.

AP Macroeconomics

What Is Fiscal Policy?

Fiscal policy refers to the use of government spending (\( G \)) and taxation (\( T \)) to influence the level of aggregate demand in the economy. It is enacted by Congress and the President, not the Federal Reserve.

The AD-AS Framework

Real GDP Price Level SRAS LRAS AD E \( Y_f \)

The economy's short-run equilibrium occurs where AD intersects SRAS. If actual GDP is below full-employment GDP (\( Y_f \)), we have a recessionary gap. If above, an inflationary gap.

Two Types: Expansionary vs. Contractionary

Expansionary
Used during a recession: increase \( G \) or decrease \( T \) to shift AD right and close a recessionary gap.
Contractionary
Used during inflation: decrease \( G \) or increase \( T \) to shift AD left and close an inflationary gap.

The Spending Multiplier

When the government increases spending by \( \Delta G \), the total change in GDP is greater than \( \Delta G \) because of the multiplier effect. Each dollar spent becomes income for someone else, who then spends a fraction of it.

The Tax Multiplier

Tax cuts also shift AD right, but the multiplier is smaller than the spending multiplier because households save a portion of the tax cut rather than spending all of it.

Spending vs. Tax Multiplier: Key Distinction

Spending Multiplier Tax Multiplier
Formula \( \frac{1}{1 - MPC} \) \( \frac{-MPC}{1 - MPC} \)
If \( MPC = 0.75 \) 4 -3
Absolute size Larger Smaller by 1
Why? All of \( \Delta G \) enters spending stream Part of \( \Delta T \) is saved, not spent
Direct impact on AD Immediate: \( G \) is in AD directly Indirect: changes \( C \) via disposable income

Expansionary Fiscal Policy in AD-AS

Real GDP Price Level SRAS LRAS AD₁ AD₂ E₁ E₂ Y₁ Y₂ P₁ P₂ Gap

Increasing \( G \) or cutting \( T \) shifts AD from AD₁ to AD₂. Real GDP rises from Y₁ to Y₂, closing the recessionary gap. The price level also rises.

Contractionary Fiscal Policy in AD-AS

Real GDP Price Level SRAS LRAS AD₁ AD₂ E₁ E₂ Y₁ Y₂ P₁ P₂ Gap closes

Decreasing \( G \) or raising \( T \) shifts AD from AD₁ to AD₂. Real GDP falls from Y₁ to Y₂, closing the inflationary gap and reducing the price level.

How to Apply Fiscal Policy Analysis

1
Identify the gap: Is actual GDP above or below \( Y_f \)? Recessionary = below, inflationary = above.
2
Choose the correct policy: Recessionary gap: increase \( G \) or cut \( T \). Inflationary gap: cut \( G \) or raise \( T \).
3
Calculate the multiplier: Spending multiplier = \( \frac{1}{MPS} \). Tax multiplier = \( \frac{-MPC}{MPS} \).
4
Find the needed change: \( \Delta G = \frac{\text{GDP gap}}{\text{spending multiplier}} \) or \( \Delta T = \frac{\text{GDP gap}}{\text{tax multiplier}} \).
5
Predict the outcome: AD shifts, real GDP moves toward \( Y_f \), price level adjusts, unemployment changes.

Worked Example: Recessionary Gap

The economy has a recessionary gap of \$100 billion. The MPC is 0.8. How much should the government increase spending to close the gap?

1
Find the multiplier: \( \frac{1}{1 - 0.8} = \frac{1}{0.2} = \) 5
2
Solve for \( \Delta G \): \( \Delta G = \frac{\$100\text{B}}{5} = \) \$20 billion
3
Result: A \$20B increase in \( G \) causes a \$100B increase in GDP, closing the gap.

Worked Example: Tax Cut Approach

Same scenario: \$100 billion recessionary gap, MPC = 0.8. Instead of spending, the government uses a tax cut. How large must it be?

1
Find the tax multiplier: \( \frac{-MPC}{MPS} = \frac{-0.8}{0.2} = \) -4
2
Solve for \( \Delta T \): \( \Delta T = \frac{\$100\text{B}}{-4} = \) -\$25 billion (a tax cut of \$25B)
3
Result: A \$25B tax cut raises GDP by \$100B. Notice: \$25B > \$20B, so tax cuts require a larger dollar amount.

Worked Example: Inflationary Gap

Real GDP is \$60 billion above full employment. MPC = 0.75. The government decides to raise taxes. By how much?

1
Tax multiplier: \( \frac{-0.75}{0.25} = \) -3
2
Need GDP to fall by \$60B: \( \Delta T = \frac{-\$60\text{B}}{-3} = \) +\$20 billion (a tax increase)
3
Result: A \$20B tax hike reduces GDP by \$60B, closing the inflationary gap and lowering the price level.

Limitations: Crowding Out

Gov't borrows Demand for loanable funds ↑ Interest rates rise Private Investment falls ↓ Net effect: AD shift is partially offset The multiplier effect is weakened by crowding out

Common Mistakes to Avoid

✕ Confusing Multipliers
Using the spending multiplier \( \frac{1}{MPS} \) for a tax change question, or vice versa. The tax multiplier is always smaller in absolute value.
✕ Wrong Direction
Applying expansionary policy to an inflationary gap. Recession = expand, inflation = contract. Mixing them up worsens the problem.
✕ Ignoring Crowding Out
Assuming the full multiplier effect occurs in practice. Deficit-financed spending can raise interest rates and crowd out private investment.

Summary: Fiscal Policy Toolkit

Expansionary Contractionary
When to use Recessionary gap Inflationary gap
Government spending Increase \( G \) Decrease \( G \)
Taxes Cut \( T \) Raise \( T \)
AD shift Right → ← Left
Real GDP Increases Decreases
Price level Rises Falls
Unemployment Decreases Increases

Question 1 of 5

If the MPC is 0.8, what is the value of the spending multiplier?

Question 2 of 5

The economy is experiencing high unemployment and low GDP growth. Which fiscal policy action is most appropriate?

Question 3 of 5

With an MPC of 0.75, the government needs to close a \$200 billion recessionary gap using only a tax cut. How large must the tax cut be?

Question 4 of 5

Why is the spending multiplier larger than the tax multiplier in absolute value?

Question 5 of 5

Crowding out occurs when expansionary fiscal policy leads to: