I n t h I s c h a p t e r y o u w I l L

partly offsets the
initial increase in
aggregate demand.
AD
2
AD
3
$20 billion
1. When an
increase in
government 
purchases
increases
aggregate
demand . . . 
F i g u r e 3 2 - 5
T
HE
C
ROWDING
-O
UT
E
FFECT
.
Panel (a) shows the money
market. When the government
increases its purchases of goods
and services, the resulting
increase in income raises the
demand for money from 
MD
1
to
MD
2
, and this causes the
equilibrium interest rate to rise
from 
r
1
to 
r
2
. Panel (b) shows the
effects on aggregate demand.
The initial impact of the increase
in government purchases shifts
the aggregate-demand curve
from 
AD
1
to 
AD
2
. Yet, because
the interest rate is the cost of
borrowing, the increase in the
interest rate tends to reduce
the quantity of goods and
services demanded, particularly
for investment goods. This
crowding out of investment
partially offsets the impact of
the fiscal expansion on
aggregate demand. In the end,
the aggregate-demand curve
shifts only to 
AD
3
.

---

7 5 0
PA R T T W E LV E
S H O R T - R U N E C O N O M I C F L U C T U AT I O N S
tax cut to be permanent, they will view it as adding substantially to their financial
resources and, therefore, increase their spending by a large amount. In this case,
the tax cut will have a large impact on aggregate demand. By contrast, if house-
holds expect the tax change to be temporary, they will view it as adding only
slightly to their financial resources and, therefore, will increase their spending by
only a small amount. In this case, the tax cut will have a small impact on aggregate
demand.
An extreme example of a temporary tax cut was the one announced in 1992. In
that year, President George Bush faced a lingering recession and an upcoming re-
election campaign. He responded to these circumstances by announcing a reduc-
tion in the amount of income tax that the federal government was withholding
from workers’ paychecks. Because legislated income tax rates did not change,
however, every dollar of reduced withholding in 1992 meant an extra dollar of
taxes due on April 15, 1993, when income tax returns for 1992 were to be filed.
Thus, Bush’s “tax cut” actually represented only a short-term loan from the gov-
ernment. Not surprisingly, the impact of the policy on consumer spending and ag-
gregate demand was relatively small.
Q U I C K Q U I Z :
Suppose that the government reduces spending on highway
construction by $10 billion. Which way does the aggregate-demand curve
shift? Explain why the shift might be larger than $10 billion. Explain why
the shift might be smaller than $10 billion.
I
N TH E
1990
S
, J
APAN EXPERIENCED A LONG
and deep recession. As the decade was
coming to a close, it looked like an end
might be in sight, in part because the
government was using fiscal policy to
expand aggregate demand.