Spending and Taxes Rise Together
Government spending and taxes rise by the same amount, and because the spending multiplier is larger than the tax multiplier, aggregate demand still shifts right.
Spending and Taxes Rise Together
Fiscal Policy (AD-AS)Government spending and taxes rise by the same amount, and because the spending multiplier is larger than the tax multiplier, aggregate demand still shifts right.
Equilibrium at Real GDP (Y) 92, Price Level (PL) 66
Below potential, deficit unchanged
The economy starts with AD crossing SRAS to the left of LRAS, so real GDP is below the full-employment level of output and a recessionary gap is open. Lawmakers want to stimulate the economy without borrowing another dollar, so every dollar of new spending is matched by a dollar of new taxes.
Now try it yourself: shift the curves in a graded FRQ drill, or open this graph in the free sandbox.
Students predict what happens before the graph moves. No accounts, nothing graded.
Spending and Taxes Rise Together, step by step
- 1
Below potential, deficit unchanged
The economy starts with AD crossing SRAS to the left of LRAS, so real GDP is below the full-employment level of output and a recessionary gap is open. Lawmakers want to stimulate the economy without borrowing another dollar, so every dollar of new spending is matched by a dollar of new taxes.
- 2
Spending pulls right, taxes pull left
Government spending (G) is a component of aggregate demand, so the new program raises spending on domestic output at every price level and pulls AD right. The tax that pays for it cuts disposable income, so consumption (C) falls and pulls AD left. The two pulls do not cancel, and AD ends up to the right of where it started. Production costs have not changed, so SRAS stays where it is.
- 3
Why the right pull wins
The two multipliers are not the same size. A spending increase enters aggregate demand at full value before any household decides anything, while a tax increase bites only when households cut their own spending, and they cover part of the tax bill out of saving instead. So the spending multiplier, 1/(1 - MPC), outweighs the tax multiplier, -MPC/(1 - MPC), in absolute value, and the two together leave AD shifted right by about the size of the program itself.
- 4
A small step toward potential
AD crosses the unchanged SRAS at a higher real GDP and a higher price level, so a little of the recessionary gap has closed. Output is still well short of the full-employment level marked by LRAS, because the taxes drained most of what the spending added. The same program paid for by borrowing would have moved AD about five times as far.
Where it ends up
A spending increase paid for entirely by higher taxes still shifts AD right, because the spending multiplier, 1/(1 - MPC), is larger in absolute value than the tax multiplier, -MPC/(1 - MPC). Real GDP and the price level both rise, but far less than deficit financing would deliver.
Now draw it yourself
Same graph, graded on whether you move the right curve and leave the rest alone.
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