AP Macroeconomics

Class 4
 • Discuss how the AS–AD model is used to
formulate macroeconomic policy
• Explain the rationale for stabilization policy
• Describe the importance of fiscal policy as a
tool for managing economic fluctuations
What You Will • Identify the policies that constitute
expansionary fiscal policy and those that
Learn in this constitute contractionary fiscal policy
Module

Section 4 | Module 20
 Classical vs Keynesian

• Classical economics
• The idea that markets regulate themselves
• Adam Smith, David Ricardo, and Thomas Malthus are all
considered classical economists.

• The Great Depression that began in 1929 challenged the ideas of classical
economics.

Section 4 | Module 16
 Classical vs Keynesian

• Keynesian economics is the idea that the

economy is composed of three sectors —
individuals, businesses, and government — and
that government actions can make up for changes
in the other two
• Keynesian economists argue that fiscal policy can
be used to fight both recession or depression and
inflation
• Keynes believed that the government could
increase spending during a recession to
counteract the decrease in consumer spending
• Among the most influential economists of the
20th century
Section 4 | Module 16
 The Government Budget and Total Spending

• Fiscal policy is the use of taxes, government transfers, or government

purchases of goods and services to shift the aggregate demand curve.

Section 4 | Module 20
 Government budget
• Budget surplus:
• When taxes collected are more than the amount of government
spending, the difference between taxes and government spending is a
budget surplus.
• Budget deficit:
• When taxes collected are less than the amount of government
spending, the difference between taxes and government spending is a
budget deficit.
• Balanced budget:
• When the amount of taxes collected is exactly equal to the amount of
government spending.
Section 5 | Module 29
Discretionary Fiscal Policy

Expansionary Fiscal Policy

(The GAS)

• Laws that shift AD to the right

• Close a Recessionary Gap
• Reduce unemployment and increase
GDP
– Increase Government Spending
– Decrease Taxes on consumers
– Combinations of the Two

Section 4 | Module 16
 Discretionary Fiscal Policy

Contractionary Fiscal Policy

(The BRAKE)

• Laws that shift AD to the left

• Close a Inflationary Gap
• Reduce inflation and decrease GDP
– Decrease Government Spending
– Tax Increases
– Combinations of the Two

Section 4 | Module 16
Sources of Tax and Government spending in the U.S.,
2013

Section 4 | Module 20
 Automatic stabilizers

• Rules governing taxes and some transfers act as

automatic stabilizers, automatically reducing the
size of fluctuations in the business cycle.
• The U.S. Progressive Income Tax System acts
counter cyclically to stabilize the economy.
• When GDP is down, the tax burden on consumers
is low, promoting consumption, increasing AD.
• When GDP is up, more tax burden on consumers,
discouraging consumption, decreasing AD.

Section 4 | Module 21
Fiscal Policy Grid

Section 4 | Module 16
 Check Point

• The appropriate fiscal policy to remedy inflation calls for:

• The appropriate fiscal policy to remedy recession calls for:

A. The federal government to run a deficit.

B. The federal government to run a surplus.
C. Increased taxes and government spending.
D. Decreased government spending and taxes.
E. Decreased taxes and increased government spending.

Section 4 | Module 16
Summary
1. Many economists advocate active stabilization policy: using fiscal or
monetary policy to offset demand shocks.
2. Negative supply shocks pose a policy dilemma:
a policy that counteracts the fall in aggregate output by increasing
aggregate demand will lead to higher inflation, but a policy that counteracts
inflation by reducing aggregate demand will deepen the output slump.
3. Fiscal policy is the use of taxes, government transfers, or government
purchases of goods and services to shift the aggregate demand curve.
4. Expansionary fiscal policy shifts the aggregate demand curve rightward.
5. Contractionary fiscal policy shifts the aggregate demand curve leftward.

Section 4 | Module 20
 • Explain why fiscal policy has a multiplier effect
• Describe how automatic stabilizers influence
the multiplier effect
What You Will
Learn in this
Module

Section 4 | Module 21
 Using the Multiplier to Estimate
the Influence of Government Policy

• Fiscal policy has a multiplier effect on the

economy.
• Fiscal policy can take the form of changes in
taxes, transfers, and government spending.
• Expansionary fiscal policy leads to an increase
in real GDP larger than the initial rise in
aggregate spending caused by the policy.
• Conversely, contractionary fiscal policy leads to
a fall in real GDP larger than the initial
reduction in aggregate spending caused by the
policy.

Section 4 | Module 21
 The Multiplier: An Informal Introduction

• The marginal propensity to consume, or MPC, is the increase in

consumer spending when disposable income rises by $1.

• The marginal propensity to save, or MPS, is the increase in household

savings when disposable income rises by $1.

• In a closed economy, MPS + MPC = 1

Section 4 | Module 16
 The Multiplier: An Informal Introduction
Increase in investment spending = $100 billion
+ Second-round increase in consumer spending
= MPC × $100 billion
+ Third-round increase in consumer spending
= MPC2 × $100 billion
+ Fourth-round increase in consumer spending
= MPC3 × $100 billion
…
Total increase in real GDP
= (1 + MPC + MPC2 + MPC3 + . . .) × $100 billion

Remember how to calculate the sum of geometric progression in

mathematics?
Section 4 | Module 16
 The Multiplier: An Informal Introduction
• The $100 billion increase in investment spending sets off a chain reaction
in the economy.
• The net result of this chain reaction is that a $100 billion increase in
investment spending leads to a change in real GDP that is a multiple of the
size of that initial change in spending.
• How large is this multiple?

Section 4 | Module 16
 The Multiplier: Numerical Example

Rounds of Increases of Real GDP When MPC = 0.6

• In the end, real GDP rises
by $250 billion as a
consequence of the
initial $100 billion rise in
investment spending:
1/(1 − 0.6) × $100 billion
= 2.5 × $100 billion
= $250 billion

Section 4 | Module 16
 Multiplier Effects of Changes in Taxes and
Government Transfers
• Example: The government hands out $100 billion in the form of tax cuts.
• What will be the effect now?
– MPC × $100 billion. For example, if MPC = 0.6, the first-round increase in
consumer spending will be $60 billion.
– This initial rise in consumer spending will lead to a series of subsequent
rounds in which real GDP, disposable income, and consumer spending rise
further.
– Total increase in real GDP
= (MPC + MPC2 + MPC3 + . . .) × $100 billion
– 60 + 36 + 21.6 + … = 150
• Tax Multipliers = - MPC/(1-MPC)
• Spending multiplier + tax multiplier = 1

Section 4 | Module 21
 Multiplier Effects of Changes
in Government Transfers and Taxes
• The multiplier on changes in taxes or
transfers, - MPC/(1 − MPC), because
part of any change in taxes or
transfers is absorbed by savings.
• The results from changes in taxes are
complicated by the fact that
governments rarely impose lump sum
taxes.
• Changes in government purchases
have a more powerful effect on the
economy than equal-sized changes in
taxes or transfers.

Section 4 | Module 21
 Consumer Spending

• The consumption function is an equation showing how an individual

household’s consumer spending varies with the household’s current
disposable income.

• Autonomous Consumer Spending is the amount of money a household

would spend if it had not disposable income.

Section 4 | Module 16
Disposable Income and Consumer Spending

Current Disposable
Income and Consumer
Spending for U.S.
Households in 2012

Section 4 | Module 16
The Consumption Function

Section 4 | Module 16
 The Consumption Function

• Deriving the Slope of the Consumption Function

Section 4 | Module 16
Shifts of the Aggregate Consumption Function

The aggregate consumption function

shifts in response to changes in expected
future disposable income and changes in
aggregate wealth.

Section 4 | Module 16
Shifts of the Aggregate Consumption Function

Section 4 | Module 16
 Check Point

Given the marginal propensity to consume is 0.75 and the country currently
has a recessionary gap of 300 billion.
a) What level of government spending would be necessary to close the
gap?
b) What level of tax reduction would be necessary to close the gap?
c) If the government decides to run a balanced budget (increasing
government spending and tax at the same time), what level of spending
and tax is needed?

Section 4 | Module 16
Summary
1. An autonomous change in aggregate spending leads to a chain reaction in
which the total change in real GDP is equal to the multiplier times the
initial change in aggregate spending.
2. The size of the multiplier, 1/(1 − MPC), depends on the marginal propensity
to consume, MPC, the fraction of an additional dollar of disposable income
spent on consumption.
3. The consumption function shows how an individual household’s consumer
spending is determined by its current disposable income.
4. The aggregate consumption function shows the relationship for the entire
economy.
Section 4 | Module 16
Summary
4. Rules governing taxes—with the exception of lump-sum taxes—and some
transfers act as automatic stabilizers, reducing the size of the multiplier and
automatically reducing the size of fluctuations in the business cycle.
5. Discretionary fiscal policy arises from deliberate actions by policy makers
rather than from the business cycle.

Section 4 | Module 21
 • Describe how the loanable funds market
matches savers and investors
• Identify the determinants of supply and
demand in the loanable funds market
• Explain how the two models of interest rates
What You Will can be reconciled

Learn in this
Module

Section 5 | Module 29
 How do government finance expansionary
fiscal policy?
• Creating Money
• The government can pay for budget deficits by creating money.
Creating money, however, increases demand for goods and services
and can lead to inflation.

• Borrowing Money
• The government can also pay for budget deficits by borrowing money.
• The government borrows money by selling bonds, such as United
States Savings Bonds, Treasury bonds, Treasury bills, or Treasury notes.
The government then pays the bondholders back at a later date.

Section 5 | Module 29
 The Demand for Loanable Funds
Interest
rate
• The demand for loanable
A
funds represents the behavior
12% of borrowers and the quantity
of loans demanded. The lower
the interest rate, the less
expensive it is to borrow.

B
4

Demand for loanable funds, D

0 $150 450 Quantity of loanable funds

(billions of dollars)
Section 5 | Module 29
 The Supply for Loanable Funds
Interest
Supply of loanable funds, S
rate
• The supply of loanable funds
represents the behavior of all
12%
Y of the savers in an economy.
The higher interest rate that a
saver can earn, the more likely
they are to save money.
• The supply of loanable funds
4
X
shows that the quantity of
savings available.

0 $150 450 Quantity of loanable funds

(billions of dollars)
Section 5 | Module 29
 Equilibrium in the Loanable Funds Market
Interest
rate
Projects with rate of return • The equilibrium in the
8% or greater are funded.
market for loanable
funds is achieved when
12%
Offers not accepted from the quantities of loans
lenders who demand interest
rate of more than 8%. that borrowers want are
r* 8 the same as the
Projects with rate of return
less than 8% are not funded. quantity of savings that
savers provide.
4
• The interest rate adjusts
Offers accepted from lenders
willing to lend at interest rate to make these equal.
of 8% or less.
0
$300 Quantity of loanable funds
Q* (billions of dollars) Section 5 | Module 29
 An Increase in the Demand for Loanable Funds
Real
Interest • Factors that can cause
rate
the demand curve for
S loanable funds to shift
An increase in the include:
demand for loanable
r funds . . . – Changes in
2
. . . leads to a rise
in the equilibrium
perceived business
interest rate. r
1
opportunities
– Changes in the
D government’s
D
2 borrowing
1
Quantity of loanable funds
Section 5 | Module 29
 An Increase in the Supply of Loanable Funds
Interest
rate
S
1
S
2

r
… leads to a 1
fall in An increase in the
equilibrium supply for
interest rate. loanable funds . . .
r
2
D

Section 5 | Module 29
 Shifts of the Supply of Loanable Funds
Factors that can cause the supply of loanable funds to shift include:
– Changes in private savings behavior: Between 2000 and 2006 rising home
prices in the United States made many homeowners feel richer, making them
willing to spend more and save less. This shifted the supply of loanable funds
to the left.
– Changes in capital inflows: The U.S. has received
large capital inflows in recent years, with much
of the money coming from China and the
Middle East. Those inflows helped fuel a big
increase in residential investment spending
from 2003 to 2006. As a result of the worldwide
slump, those inflows began to trail off in 2008.
Section 5 | Module 29
 Check Point

Interest rates in Hamsterville have fallen and, as a result, the net return to
investment projects are higher than before and now firms are more willing
to take out loans.
Which of the following changes would reflect what is described in the
statement above?
A. The supply of money increased.
B. The demand for money increased.
C. The demand for loanable funds increased.
D. The supply of loanable funds increased.
E. The quantity of loanable funds demanded increased.

Section 4 | Module 16
Summary
1. The hypothetical loanable funds market shows how loans from savers are
allocated among borrowers with investment spending projects.
2. In equilibrium, only those projects with a rate of return greater than or
equal to the equilibrium interest rate will be funded.
3. Changes in perceived business opportunities and in government borrowing
shift the demand curve for loanable funds; changes in private savings and
capital inflows shift the supply curve.

Section 5 | Module 29