Fiscal policy may not affect the economy as strongly as predicted by the multiplier. An increase in government purchases causes the interest rate to rise. A higher interest rate reduces investment spending. This reduction in aggregate demand that results when a fiscal expansion increases the interest rate is called the crowding-out effect. The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand. Conclusion When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger. Questions 1: Fill in the blanks in the following table: Income Consumption Saving MPC MPS APC APS ($) 1000 400 0.60 2000 900 1100 3000 1400 0.50 4000 2100 2: What is the level of savings if: (a) Disposable income is $500 and consumption is $450 (b) Disposable income is $1200 and the APS is 0.90 (c) The MPC equals 0.90, disposable income rises from $800 to $900, and saving is originally $120 when income equals $800 3: What is the marginal propensity to consume if: (a) Consumption increases by $75 when disposable income rises by $100 (b) Consumption falls by $50 when disposable income falls by $100
Fiscal policy may not affect the economy as strongly as predicted by the multiplier. An increase in government purchases causes the interest rate to rise. A higher interest rate reduces investment spending. This reduction in aggregate demand that results when a fiscal expansion increases the interest rate is called the crowding-out effect. The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand. Conclusion When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger. Questions 1: Fill in the blanks in the following table: Income ($) Consumption Saving MPC MPS APC APS 1000 400 0.60 2000 900 1100 3000 1400 0.50 4000 2100 2: What is the level of savings if: (a) Disposable income is $500 and consumption is $450 (b) Disposable income is $1200 and the APS is 0.90 (c) The MPC equals 0.90, disposable income rises from $800 to $900, and saving is originally $120 when income equals $800 3: What is the marginal propensity to consume if: (a) Consumption increases by $75 when disposable income rises by $100 (b) Consumption falls by $50 when disposable income falls by $100
the_keynesian_multiplier.docx