TAILIEUCHUNG - Ten Principles of Economics - Part 73

Ten Principles of Economics - Part 73. Economics is the study of how society manages its scarce resources. In most societies, resources are allocated not by a single central planner but through the combined actions of millions of households and firms. Economists therefore study how people make decisions: how much they work, what they buy, how much they save, and how they invest their savings. Economists also study how people interact with one another. | CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 745 right. There are two macroeconomic effects that make the size of the shift in aggregate demand differ from the change in government purchases. The first the multiplier effect suggests that the shift in aggregate demand could be larger than 20 billion. The second the crowding-out effect suggests that the shift in aggregate demand could be smaller than 20 billion. We now discuss each of these effects in turn. THE MULTIPLIER EFFECT When the government buys 20 billion of goods from Boeing that purchase has repercussions. The immediate impact of the higher demand from the government is to raise employment and profits at Boeing. Then as the workers see higher earnings and the firm owners see higher profits they respond to this increase in income by raising their own spending on consumer goods. As a result the government purchase from Boeing raises the demand for the products of many other firms in the economy. Because each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar government purchases are said to have a multiplier effect on aggregate demand. This multiplier effect continues even after this first round. When consumer spending rises the firms that produce these consumer goods hire more people and experience higher profits. Higher earnings and profits stimulate consumer spending once again and so on. Thus there is positive feedback as higher demand leads to higher income which in turn leads to even higher demand. Once all these effects are added together the total impact on the quantity of goods and services demanded can be much larger than the initial impulse from higher government spending. Figure 32-4 illustrates the multiplier effect. The increase in government purchases of 20 billion initially shifts the aggregate-demand curve to the right from AD1 to AD2 by exactly 20 billion. But when consumers respond by increasing their .

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