Changes in Government Purchases

One policy through which the government could seek to shift the aggregate demand curve is a change in government purchases. Figure An Increase in Government Purchases shows the effect of an increase in government purchases of $200 billion. The initial price level is P ₁and the initial equilibrium real GDP is $12,000 billion. Suppose the multiplier is 2. The $200 billion increase in government purchases increases the total quantity of goods and services demanded, at a price level of P ₁, by $400 billion (the $200 billion increase in government purchases times the multiplier) to $12,400 billion. The aggregate demand thus shifts to the right by that amount to AD ₂. The equilibrium level of real GDP rises to $12,300 billion, and the price level rises to P ₂.

Figure An Increase in Government Purchases

P G AD P

A reduction in government purchases would have the opposite effect. The aggregate demand curve would shift to the left by an amount equal to the initial change in government purchases times the multiplier. Real GDP and the price level would fall.

Changes in Income Taxes

Income taxes affect the consumption component of aggregate demand. An increase in income taxes reduces disposable personal income and thus reduces consumption (but by less than the change in disposable personal income). That shifts the AD curve leftward by an amount equal to the initial change in consumption that the change in income taxes produces times the multiplier.A reduction in income taxes increases disposable personal income, increases consumption (but by less than the change in disposable personal income), and increases aggregate demand.

Suppose, for example, that income taxes are reduced by $200 billion. Only some of the increase in disposable personal income will be used for consumption and the rest will be saved. Suppose the initial increase in consumption is $180 billion. Then the shift in the AD curve will be a multiple of $180 billion; if the multiplier is 2, AD will shift to the right by $360 billion. Thus, as compared to the $200-billion increase in government purchases that we saw in Figure An Increase in Government Purchases, the shift in the AD curve due to an income tax cut is somewhat less, as is the effect on real GDP and the price level.

Changes in Transfer Payments

Changes in transfer payments, like changes in income taxes, alter the disposable personal income of households and thus affect their consumption, which is a component of aggregate demand. A change in transfer payments will thus shift the AD curve because it will affect consumption. Because consumption will change by less than the change in disposable personal income, a change in transfer payments of some amount will result in a smaller change in real GDP than would a change in government purchases of the same amount. As with income taxes, a $200-billion increase in transfer payments will shift the AD curve to the right by less than the $200-billion increase in government purchases that we saw in Figure An Increase in Government Purchases.

Key concepts

· Discretionary fiscal policy may be either expansionary or contractionary.

· A change in government purchases shifts the aggregate demand curve at a given price level by an amount equal to the initial change in government purchases times the multiplier. The change in real GDP, however, will be reduced by the fact that the price level will change.

· A change in income taxes or government transfer payments shifts the aggregate demand curve by a multiple of the initial change in consumption (which is less than the change in personal disposable income) that the change in income taxes or transfer payments causes. Then, the change in real GDP will be reduced by the fact that the price level will change.

· A change in government purchases has a larger impact on the aggregate demand curve than does an equal change in income taxes or transfers.

 

 

Multiple Choice Test

1. If a tax rate increases with an increase in incomes, such a tax is called:

a) progressive;

b) regressive;

c) direct;

d) indirect