Economics Micro & Macro (CliffsAP)

Figure 5-2

The Effects of Government Spending

The spending multiplieris used by the government to determine the impact of the government’s dollar on the econ-
omy. If the government’s goal is to reduce aggregate demand by $20 billion, then, depending on the marginal propen-
sity to consume, the government may reduce its spending by only $5 billion. Let’s assume that the economy’s marginal
propensity to consume (Chapter 3) is 0.75. That is, consumers spend 75 percent of any additional income they earn. To
achieve a $20 billion decrease in aggregate demand, the government needs to decrease spending only by $5 billion. The
basic idea behind the multiplier is to measure the impact on the economy that money spent by the government has.
Figure 5-3 simplifies the economy’s reaction to changes in government policies.

Figure 5-3

Built-In Stabilizers

Government tax revenues fluctuate automatically over the course of a business cycle to stabilize the economy. This type
of taxation is considered nondiscretionary fiscal policy. A built-in stabilizeris anything that increases or reduces a
government’s budget deficit without requiring “action” by policymakers.

Expansionary

Increase

Government

Spending

Decrease

Taxes

Goals

To Fight Inflation

To Fight A Recession

Contractionary

Decrease

Government

Spending

Increase

Ta x e s

Price

Level

AD^2

AS

Real GDP

AD^1

Fiscal Policy