Spring 2020: the U.S. economy lost twenty million jobs in a month. Congress didn't wait for wages to "eventually adjust" — it pushed out over $2 trillion in spending and payments within weeks. That's fiscal policy: the deliberate use of the government's budget to move aggregate demand. The AP exam's favorite part isn't the politics — it's the arithmetic. A dollar of government spending raises GDP by more than a dollar, a dollar of tax cuts raises it by less than that, and the exam expects you to know exactly how much and exactly why. The multiplier is the closest thing this course has to a magic trick, and today you learn how it's done.
Fiscal policy = changes in government purchases (G) and/or taxes/transfers (T) to influence AD.
| Gap | Policy | Tools | AD |
|---|---|---|---|
| Recessionary (Y < Yf) | Expansionary | ↑G, ↓taxes, ↑transfers | Right |
| Inflationary (Y > Yf) | Contractionary | ↓G, ↑taxes, ↓transfers | Left |
On the AD-AS graph: shift AD toward the LRAS line; output and price level move together (PL rises with expansion, falls with contraction). Expansionary policy in a recession deliberately does what self-correction would do slowly — but through demand instead of wages.
When households receive an extra dollar of income, they spend part and save part:
MPC = Δconsumption/Δincome MPS = Δsaving/Δincome MPC + MPS = 1
Why spending multiplies: the government buys $100M of bridges → construction workers earn $100M → with MPC = 0.8 they spend $80M → shopkeepers earn $80M and spend $64M → … Each round adds spending; the geometric series sums to:
Spending multiplier = 1/MPS = 1/(1 − MPC)
With MPC = 0.8: multiplier = 1/0.2 = 5. A $100M spending increase ultimately raises real GDP by up to $500M. The same multiplier applies to any initial change in spending — a fall in investment multiplies downward identically.
The tax multiplier is smaller and opposite in sign:
Tax multiplier = −MPC/MPS
Why smaller: a $100M tax cut doesn't inject $100M of spending — households save $20M of it (MPC = 0.8), so only $80M enters round one. Result: −(0.8/0.2) = −4; a $100M tax cut raises GDP by up to $400M. Transfers work like negative taxes (same magnitude logic).
Balanced-budget insight: raise G and taxes by the same $100M → +5×100 − 4×100 = +$100M. The balanced-budget multiplier is 1.
Apply It: MPC = 0.75. (1) Spending multiplier? (2) Tax multiplier? (3) The economy has a $300B recessionary gap in real GDP. How much new G closes it? How large a tax cut would? → (1) 1/0.25 = 4. (2) −0.75/0.25 = −3. (3) G: 300/4 = $75B; tax cut: 300/3 = $100B — tax cuts must be bigger to do the same job.
(Real-world multipliers are blunted by taxes, imports, and price-level rises along SRAS — the formula gives the maximum. If asked "at most," use it straight.)
A budget deficit = spending > tax revenue this year; national debt = accumulated deficits. Expansionary fiscal policy usually means deficits — and deficits must be borrowed.
Crowding out: government borrowing increases the demand for loanable funds → the real interest rate rises → private investment (and interest-sensitive consumption) falls, offsetting part of the stimulus. There's the real-interest-rate thread again: fiscal policy tugs the same rope that investment hangs from. The full graph treatment is Lesson 11; for now, know the chain: deficit → borrow → r↑ → I↓. Long-run version: less investment today = slower capital accumulation = slower LRAS growth.
[GRAPH: Expansionary fiscal policy closing a recessionary gap
X-axis: Real GDP (Y)
Y-axis: Price level (PL)
Curves: LRAS vertical at Yf; SRAS upward; AD₁ crossing SRAS at Y₁ < Yf (PL₁)
Shift: government raises purchases → AD shifts right from AD₁ to AD₂ →
new equilibrium at (Yf, PL₂ > PL₁)
Effect: output rises to potential; price level rises as the cost of the rescue]
AP labeling requirements: show the initial gap before shifting anything; arrow on the AD shift; both equilibria dashed to both axes. State the direction of the price level — stimulus is never free; PL rises. For contractionary policy in an inflationary gap, mirror the picture: AD left, output falls to Yf, price level falls.
1. D. New legislation changing government purchases = discretionary fiscal policy. A: bond purchases are monetary policy. B: that's an automatic stabilizer — no new decision. C: deficit reduction is contractionary — wrong direction for a recession. E: private bank behavior is neither.
Fix: Discretionary fiscal = a new law moving G or T; central banks and automatic rules don't qualify.
2. B. 1/(1 − 0.9) = 1/0.1 = 10. A: that's the MPC itself. C: uses MPC/MPS. D: inverts. E: decimal slip.
Fix: Spending multiplier = 1/MPS; convert MPC to MPS first.
3. E. Multiplier = 1/0.2 = 5; 5 × $50B = $250B. A: forgets multiplication. B: multiplies by MPC once. C: divides by MPC. D: uses multiplier of 4 (the tax multiplier's magnitude).
Fix: ΔGDP = multiplier × ΔG — compute the multiplier first, then scale.
4. C. Round one of a tax cut leaks MPS × the cut into saving; only MPC × the cut is spent. A/B: irrelevant timing/incidence claims. D: crowding out affects both tools and isn't the reason. E: MPC applies to household income changes.
Fix: G enters spending 100% in round one; tax cuts enter only MPC% — hence the smaller multiplier.
5. A. Tax multiplier = −0.75/0.25 = −3; −3 × (+60) = −$180B. B: uses the spending multiplier (4 × 60) with a sign flip. C: sign error — a tax increase lowers GDP. D: multiplies by MPC only. E: mixes magnitudes.
Fix: ΔGDP = (−MPC/MPS) × ΔT — track the sign of ΔT explicitly.
6. E. Progressive taxation adjusts collections with income automatically — the definitional stabilizer. A/C/D: each requires new legislative action = discretionary. B: a permanent rate cut is a one-time discretionary change, not a built-in response.
Fix: Automatic = already in the law and responds by itself; discretionary = someone must act.
7. C. Inflationary gap → contractionary fiscal policy: cut G, raise T, AD left. A/B/E: expansionary or mixed — wrong direction. D: correct direction but monetary policy, not fiscal.
Fix: Match tool to gap AND tool to institution: Congress cools an inflationary gap by spending less/taxing more.
8. D. Borrowing raises loanable-funds demand → real rate ↑ → private I ↓: crowding out. A: fiscal borrowing doesn't shrink the money supply. B: no automatic revenue windfall. C: LRAS effects, if any, are long-run through slower capital growth — not immediate. E: higher rates typically cause appreciation (Lesson 15), and that's a secondary channel anyway.
Fix: Crowding out = deficit → r↑ → I↓; the interest rate is the transmission.
9. B. Balanced-budget multiplier = 1: +5(40) − 4(40) = 200 − 160 = +$40B. A: adds the two effects without netting. C: assumes full cancellation — forgets the multipliers differ. D: spending effect alone. E: tax effect alone.
Fix: Equal ΔG and ΔT still stimulate: net effect = the initial ΔG itself (multiplier of exactly 1).
10. A. Each round spends MPC of the previous round: 10 → 6 → 3.6 → …; total = 10 × 1/(1−0.6) = $25M. B: ignores induced consumption. C: rounds shrink, not grow linearly. D: 4M is the saved share. E: sums the leakage instead of the spending.
Fix: The multiplier is a shrinking geometric series of respending — each round = MPC × the last.
11. E. The three lags can make stimulus arrive mistimed — potentially destabilizing. A: fiscal policy plainly moves AD. B: stabilizers dampen, never fully reverse. C: it works in both gaps. D: real-world multipliers are smaller than the formula, not zero.
Fix: The strongest standard critique of discretionary policy is timing (lags), not impotence.
12. C. Falling incomes shrink progressive tax receipts while unemployment transfers rise — the deficit widens by design, with zero new laws. A: monetization is a central-bank action, unrelated to the automatic widening. B/D: contradict "no new laws." E: crowding out doesn't cut interest owed.
Fix: Recessions automatically widen deficits through stabilizers; that's evidence the cushion is working.
13. B. Start right of LRAS (inflationary gap); AD left; output returns to Yf; PL falls. A: expansionary policy from a recessionary start. C: that's a supply shock. D: LRAS doesn't move for policy. E: unrelated combination.
Fix: Draw the gap first, then move AD toward LRAS — direction follows the diagnosis.
The economy of Varena is in a recessionary gap. Its marginal propensity to consume is 0.8. Current real GDP is $760 billion; full-employment output is $800 billion.
(a) Draw a correctly labeled AD–SRAS–LRAS graph showing Varena's current equilibrium (Y₁ = $760B, PL₁) and full-employment output (Yf = $800B).
(b) Calculate the maximum spending multiplier for Varena. Show your work.
(c) Calculate the minimum increase in government purchases that could close Varena's output gap. Show your work.
(d) Instead of raising purchases, Varena's legislature considers a tax cut. Would the required tax cut be larger than, smaller than, or equal to your answer in (c)? Explain with reference to the tax multiplier.
(e) Show on your graph (or describe) the effect of the successful policy on output and the price level.
(f) Varena finances the stimulus by borrowing. Explain how this borrowing could partially offset the policy's effect on aggregate demand.
1. D. New legislation changing government purchases = discretionary fiscal policy. A: bond purchases are monetary policy. B: that's an automatic stabilizer — no new decision. C: deficit reduction is contractionary — wrong direction for a recession. E: private bank behavior is neither. Fix: Discretionary fiscal = a new law moving G or T; central banks and automatic rules don't qualify.
2. B. 1/(1 − 0.9) = 1/0.1 = 10. A: that's the MPC itself. C: uses MPC/MPS. D: inverts. E: decimal slip. Fix: Spending multiplier = 1/MPS; convert MPC to MPS first.
3. E. Multiplier = 1/0.2 = 5; 5 × $50B = $250B. A: forgets multiplication. B: multiplies by MPC once. C: divides by MPC. D: uses multiplier of 4 (the tax multiplier's magnitude). Fix: ΔGDP = multiplier × ΔG — compute the multiplier first, then scale.
4. C. Round one of a tax cut leaks MPS × the cut into saving; only MPC × the cut is spent. A/B: irrelevant timing/incidence claims. D: crowding out affects both tools and isn't the reason. E: MPC applies to household income changes. Fix: G enters spending 100% in round one; tax cuts enter only MPC% — hence the smaller multiplier.
5. A. Tax multiplier = −0.75/0.25 = −3; −3 × (+60) = −$180B. B: uses the spending multiplier (4 × 60) with a sign flip. C: sign error — a tax increase lowers GDP. D: multiplies by MPC only. E: mixes magnitudes. Fix: ΔGDP = (−MPC/MPS) × ΔT — track the sign of ΔT explicitly.
6. E. Progressive taxation adjusts collections with income automatically — the definitional stabilizer. A/C/D: each requires new legislative action = discretionary. B: a permanent rate cut is a one-time discretionary change, not a built-in response. Fix: Automatic = already in the law and responds by itself; discretionary = someone must act.
7. C. Inflationary gap → contractionary fiscal policy: cut G, raise T, AD left. A/B/E: expansionary or mixed — wrong direction. D: correct direction but monetary policy, not fiscal. Fix: Match tool to gap AND tool to institution: Congress cools an inflationary gap by spending less/taxing more.
8. D. Borrowing raises loanable-funds demand → real rate ↑ → private I ↓: crowding out. A: fiscal borrowing doesn't shrink the money supply. B: no automatic revenue windfall. C: LRAS effects, if any, are long-run through slower capital growth — not immediate. E: higher rates typically cause appreciation (Lesson 15), and that's a secondary channel anyway. Fix: Crowding out = deficit → r↑ → I↓; the interest rate is the transmission.
9. B. Balanced-budget multiplier = 1: +5(40) − 4(40) = 200 − 160 = +$40B. A: adds the two effects without netting. C: assumes full cancellation — forgets the multipliers differ. D: spending effect alone. E: tax effect alone. Fix: Equal ΔG and ΔT still stimulate: net effect = the initial ΔG itself (multiplier of exactly 1).
10. A. Each round spends MPC of the previous round: 10 → 6 → 3.6 → …; total = 10 × 1/(1−0.6) = $25M. B: ignores induced consumption. C: rounds shrink, not grow linearly. D: 4M is the saved share. E: sums the leakage instead of the spending. Fix: The multiplier is a shrinking geometric series of respending — each round = MPC × the last.
11. E. The three lags can make stimulus arrive mistimed — potentially destabilizing. A: fiscal policy plainly moves AD. B: stabilizers dampen, never fully reverse. C: it works in both gaps. D: real-world multipliers are smaller than the formula, not zero. Fix: The strongest standard critique of discretionary policy is timing (lags), not impotence.
12. C. Falling incomes shrink progressive tax receipts while unemployment transfers rise — the deficit widens by design, with zero new laws. A: monetization is a central-bank action, unrelated to the automatic widening. B/D: contradict "no new laws." E: crowding out doesn't cut interest owed. Fix: Recessions automatically widen deficits through stabilizers; that's evidence the cushion is working.
13. B. Start right of LRAS (inflationary gap); AD left; output returns to Yf; PL falls. A: expansionary policy from a recessionary start. C: that's a supply shock. D: LRAS doesn't move for policy. E: unrelated combination. Fix: Draw the gap first, then move AD toward LRAS — direction follows the diagnosis.
Exam tip: Fiscal FRQs are a fixed five-step dance: identify the gap → choose the tool → shift AD the right way → run the multiplier arithmetic → concede the price-level cost (and, if asked, crowding out). The arithmetic is 20 seconds once you've written MPC, MPS, both multipliers at the top of your work. Mock Exam 1 is next — Units 1 through 4 territory, so review Lessons 1–8 and bring the ritual.