BUSS1040 · Economics For Business Decision Making
Stabilisation Policy: Fiscal & Monetary
Topic 12 closes the course with the Keynesian cross / Planned Aggregate Expenditure model: short-run output settles where Y = PAE, and the expenditure multiplier 1/[1 − b(1 − t)] turns a spending change into a larger output change. The chapter then uses this to diagnose output gaps (contractionary vs expansionary) and to close them with fiscal policy (ΔG, ΔT) or monetary policy (the RBA cash rate). It is examined as multi-part calculation: compute the multiplier and equilibrium Y, then find the ΔG (or rate move) needed to close a stated gap.
What this chapter covers
- 011. Planned Aggregate Expenditure: PAE = C + Ip + G (+ NX)
- 022. Consumption function C = A + b·Yd, with disposable income Yd = Y − T − tY (b = MPC)
- 033. Short-run equilibrium output: Y = PAE
- 044. Equilibrium Y = (A + Ip + G − bT) / [1 − b(1 − t)]
- 055. Expenditure multiplier = 1 / [1 − b(1 − t)]
- 066. Output gaps: contractionary (Y* − Y > 0) vs expansionary (Y − Y* > 0)
- 077. Closing a gap: ΔG = gap / multiplier; a tax change works through −b·ΔT
- 088. Fiscal vs monetary policy: ΔG/ΔT vs the RBA cash rate; what makes fiscal policy more effective
The expenditure multiplier, equilibrium output and closing a gap
- 3 marksMultiplier = 1 / [1 − b(1 − t)] = 1 / [1 − 0.75(1 − 0.20)] = 1 / [1 − 0.75×0.80] = 1 / [1 − 0.60] = 1/0.40 = 2.5.
- 2 marksEquilibrium output Y = (A + Ip + G − bT) / [1 − b(1 − t)] = (200 + 150 + 190 − 0.75×40) / 0.40.
- 2 marksNumerator = 540 − 30 = 510, so Y = 510 / 0.40 = 1,275.
- 1 markTo raise Y by 50 via spending: ΔG = ΔY / multiplier = 50 / 2.5 = 20. (A direct $20 of extra G is multiplied 2.5× into $50 of output.)
Key terms
- Planned Aggregate Expenditure (PAE)
- Total planned spending in the economy: PAE = C + Ip + G (+ NX), where Ip is planned investment. Short-run equilibrium output is where actual output equals planned spending, Y = PAE — the Keynesian cross.
- Consumption function & MPC
- C = A + b·Yd, where A is autonomous consumption, b is the marginal propensity to consume (MPC), and disposable income Yd = Y − T − tY. The MPC is the fraction of each extra dollar of disposable income that is spent.
- Expenditure multiplier
- The factor by which a change in autonomous spending changes equilibrium output: 1 / [1 − b(1 − t)] with a proportional tax. A larger MPC raises it; a larger tax rate (or import propensity) lowers it because more income leaks out each round.
- Output gap
- The difference between actual output Y and potential output Y*. A contractionary (recessionary) gap is Y* − Y > 0 (output below potential, unemployment high); an expansionary gap is Y − Y* > 0 (output above potential, inflation pressure).
- Fiscal policy
- Government use of spending (G) and taxes (T) to influence output. To close a gap, ΔG = gap / multiplier; a tax change has a smaller effect, ΔY = −b·ΔT × multiplier, because only the MPC fraction of a tax cut is spent.
- Monetary policy & the cash rate
- The RBA's adjustment of the cash rate to influence spending. A lower cash rate stimulates investment and consumption (expansionary), raising PAE; open-market operations that buy bonds lower the rate. Higher rates do the reverse (contractionary).
Stabilisation Policy: Fiscal & Monetary FAQ
How do I compute the expenditure multiplier?
With a proportional tax, the multiplier is 1 / [1 − b(1 − t)], where b is the marginal propensity to consume and t is the proportional tax rate. Compute the inside first: b(1 − t) is the fraction of each extra dollar of income that gets re-spent after tax; one minus that is the leakage; the multiplier is its reciprocal. For example b = 0.75, t = 0.20 gives 1 − 0.75×0.80 = 0.40, so the multiplier = 1/0.40 = 2.5. A bigger MPC raises the multiplier; a bigger tax rate (or import propensity) lowers it.
How much should the government change G or T to close an output gap?
First size the gap (potential Y* minus actual Y, for a recessionary gap). Because spending is multiplied, the required spending change is ΔG = gap / multiplier — a smaller direct injection achieves the full output change. Taxes work less powerfully: a tax cut of ΔT raises spending by only b·ΔT initially, so ΔY = −b·ΔT × multiplier, meaning you need a LARGER tax change than spending change for the same effect. That asymmetry (spending more potent than tax changes) is a frequent exam point.
When is fiscal policy more effective, and what is 'pro-cyclical' policy?
Fiscal policy has a bigger output effect when the multiplier is large — i.e. when the MPC is high, the marginal propensity to import is low, and the proportional tax rate is small, so less income leaks out each spending round. 'Pro-cyclical' policy reinforces the cycle instead of stabilising it: cutting a budget deficit (raising T or cutting G) DURING a recession deepens the downturn, because it withdraws spending exactly when output is already below potential. Stabilisation (counter-cyclical) policy does the opposite — stimulate in downturns, restrain in booms.
How do fiscal and monetary policy differ in this model?
Both aim to shift Planned Aggregate Expenditure to close an output gap, but through different levers. Fiscal policy changes G or T directly (controlled by the government) and feeds into PAE through the multiplier. Monetary policy is run by the RBA via the cash rate: a lower rate makes borrowing cheaper, raising investment and consumption, which lifts PAE (expansionary); a higher rate restrains spending (contractionary). Open-market operations are the mechanism — buying bonds pushes the rate down. In the exam you may be asked to choose or compute either tool to reach a target output.
How is Topic 12 examined?
As a multi-part macro calculation, typically the final short-answer question. You will assemble PAE from a consumption function and the other components, compute the multiplier 1/[1 − b(1 − t)] and equilibrium Y = (A + Ip + G − bT)/[1 − b(1 − t)], identify the output gap, and find the ΔG (or tax change, or rate move) that closes it. Conceptual marks come from explaining what raises the multiplier and why fiscal policy is more or less effective — and from recognising pro-cyclical versus counter-cyclical policy.
Exam move
Anchor everything on the multiplier: write 1/[1 − b(1 − t)] first, then equilibrium Y = (A + Ip + G − bT)/[1 − b(1 − t)], then policy moves (ΔG = gap/multiplier; tax via −b·ΔT × multiplier). Keep the algebra clean by computing b(1 − t) once and reusing it. Internalise the comparative-statics intuition examiners reward — a higher MPC or lower tax/import leakage raises the multiplier, and spending changes pack more punch than equal-sized tax changes. Be fluent in diagnosing the gap (Y vs Y*) and prescribing the right direction of policy, and be able to explain why cutting a deficit in a recession is pro-cyclical. Since this is usually the last and most algebra-heavy question, practise it under time pressure on the real practice finals so the substitution is automatic.
