Fiscal Policy
Government spending, taxation, multipliers, and budget effects.
What this graph shows
This sandbox layers fiscal policy onto the AD/AS model to show how government spending and taxes move aggregate demand. Instead of dragging AD directly, you set the spending level, the tax level, and the marginal propensity to consume (MPC), and the graph applies the spending and tax multipliers before shifting AD.
Because of the multiplier, a dollar of new government spending shifts AD by more than a dollar, since it becomes income that households partly re-spend. The tax multiplier is smaller and works in reverse, since a tax cut only boosts AD through the part households choose to spend. The AD curve then jumps relative to LRAS, showing whether the policy closes a recessionary gap, overshoots into an inflationary gap, or lands at full employment.
How to read it
The axes match the AD/AS model: real GDP horizontal, price level vertical, with AD sloping down, SRAS up, and LRAS vertical at full employment. Equilibrium is where AD meets SRAS. Increasing spending or cutting taxes shifts AD right toward the LRAS line to close a recessionary gap, while raising taxes or cutting spending shifts AD left. Compare the new equilibrium to the LRAS line to see whether the policy hit full employment or shot past it.
Three things to try
- Raise the MPC from a low value toward 0.9, then apply the same spending increase. The AD shift grows noticeably larger because a higher MPC means a bigger spending multiplier and more re-spending at each round.
- Add a spending increase and a tax increase of equal size. AD still shifts right, showing the balanced-budget effect: the spending multiplier is larger than the tax multiplier, so the two do not cancel out.
- Push spending up until equilibrium crosses past LRAS. The gap flips from recessionary to inflationary, illustrating how too much stimulus overheats the economy instead of just closing the gap.
Common questions
Why does the spending multiplier make AD shift by more than the spending change?
New government spending becomes household income, and households re-spend a fraction of it set by the MPC. That re-spending becomes more income and gets re-spent again, so the total change in AD equals the original spending times 1 divided by (1 minus MPC), which is larger than the initial amount.
Why is the tax multiplier smaller than the spending multiplier?
Government spending injects the full amount into the economy directly, but a tax cut only enters through the portion households choose to spend rather than save. Because the first round is smaller, the tax multiplier is MPC divided by (1 minus MPC), one step behind the spending multiplier.
How does fiscal policy close a recessionary gap?
Expansionary fiscal policy, higher spending or lower taxes, shifts aggregate demand right. If it moves the AD curve so equilibrium output reaches the LRAS line, the recessionary gap closes and the economy returns to full employment.
Fiscal Policy: key terms
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