Lecture Thurs 23 Sep (Week 10, lecture 2)

Question 1

How does fiscal policy influence aggregate demand?

Answer 1

It influences saving, consumption, investment and growth in the long run. But in the short run, fiscal policy primarily affects the aggregate demand

Question 2

What does fiscal policy refer to?

Answer 2

This refers to the government’s choices regarding the overall level of government purchases (G), transfer payments (TR) or taxes (T)

Question 3

Give an example of how the government struggles to deal with stagflation using a decrease in AS as an example

Answer 3

An adverse shift in AS causes the output level to fall and the inflation rate to increase. This means we are in stagflation. Policymakers can accommodate the shift by expanding aggregate demand. If the government increases its spending, then the AD curve will shift to the right. This increases the output level back to Y* so we are at lower level of unemployment but at a higher rate of inflation.

Question 4

What are the two macroeconomic effects from the change in government purchases?

Answer 4

• the multiplier effect

- the crowding-out effect

Question 4

What are the two macroeconomic effects from the change in government purchases?

Answer 4

• the multiplier effect

- the crowding-out effect

Question 5

What is the multiplier effect?

Answer 5

Government purchases are said to have a multiplier effect on aggregate demand. Each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar.

Question 6

Shifts in aggregate demand can arise from changes in what four things?

Answer 6

1. consumption
2. investment
3. government purchases
4. net exports

Question 7

What is the formula for the multiplier?

Answer 7

1/(1-c)

Question 8

If c = 0.75, a $20 billion increase in government spending generates how much of increased demand for goods and services?

Answer 8

$80 billion

Question 9

When the government cuts personal income taxes, what is the effect on disposable income and consumption?

Answer 9

Disposable income increases and this increases consumption

Question 10

The size of the shift in aggregate demand resulting from a tax change is affected by what?

Answer 10

the multiplier (and the crowding out effect)

Question 11

What is the equation for the multiplier with income tax?

Answer 11

1/[1-c(1-t)]

Question 12

Calculate the multiplier when c = 0.8 and there is no income tax

Answer 12

1/[1-c]
1/[1-0.8]
1/0.2 = 5

Question 13

Calculate the multiplier when c = 0.8 and income tax t = 0.2

Answer 13

multiplier = 1/[1-c(1-t)]
1/[1-0.8(1-0.2)]
1/[1-0.64]
1/0.36
2.778

Question 14

An increase in government purchases causes what to happen to the interest rate? Why is this?

Answer 14

it causes the interest rate to increase
this is because an increase in government spending leads to an increase in the aggregate demand which increases the demand for money which increases interest rates

Question 15

What does a higher interest rate do to investment spending?

Answer 15

it reduces it

Question 16

What is the crowding out effect?

Answer 16

A higher interest rate reduces investment spending. This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding out effect. The crowding out effect tends to dampen the effects of fiscal policy on aggregate demand. When an increase in government purchases increases aggregate demand, the increase in the interest rate reduces demand, which in turn partly offsets the initial increase in AD

Question 17

What can the government do through monetary policy if there is an increase in AD?

Answer 17

An increase in AD causes an expansionary gap. This means that π>πe.
The RBNZ can increase the OCR which raises interest rates. This decreases both investment and consumption. Shifting AD back to AD1