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The Multipliers
I.
The Spending Multiplier:
A. The formula for the spending multiplier is 1/1-MPC or 1/MPS.
This is an economic tool for economists to determine how much of a
multiplied effect fiscal policy has on the economy. When government
spending or investment spending occurs, its effect on GDP is multiplied
by the circular flow model. Here the government fights recession.
B. Application of the Spending Multiplier:
If the government increased spending by $20 Billion and the MPC is .90,
how much will real GDP increase?
Answer:
Multiplier = 1/1-MPC = 10.
The Multiplied Effect = 10 x $20 Billion = $200 Billion.
C. Closing a Recessionary Gap using Government Spending:
The question becomes, if you intend to use government spending to
stimulate the economy and close a Recessionary Gap, how much should
be spent?
Example:
II.
If there is a $500 Billion Recessionary Gap and the MPC is
.75, how much should government spending increase to
close the gap?
Answer:
Well, you don’t spend $500 Billion.
Considering the circular flow of the economy, that would
over stimulate the situation, causing inflation to occur.
How much needs to be spent? Well if the MPC is .75 and
the Spending Multiplier is 1/1-MPC, the multiplier equals
4. You spend $125Billion or $500 Billion divided by 4.
The Tax Multiplier for a Tax Increase:
A. The formula for a tax increase is: -MPC/1-MPC.
The government can also have an effect on real GDP by changing taxes or
transfer payments. Tax increases or decreases also have a multiplied effect on
real GDP through circular flow. This is a fiscal policy tool for the federal
government to fight inflation.
B. Application of the Tax Multiplier for a tax increase:
If the MPC is .90 and the government increases taxes by $20 Billion, what
is the multiplied effect on real GDP?
Tax Multiplier = -MPC/1-MPC = -.9/1-.9 = -9
The Multiplied Effect = -9 x $20 Billion = Negative $180 Billion
C. Closing an Inflationary Gap using a tax increase:
The question becomes, if you intend to increase taxes to slow down the
economy and close an Inflationary Gap, how much should taxes increase?
Example:
If there is a $600 Billion Inflationary Gap and the MPC is
.75, how much should taxes increase to close the gap?
Answer:
Well, you don’t increase taxes by $600
Billion. Considering the circular flow of the economy, that
would over slow down the economy too much. How much
do taxes need to increase? Well if the MPC is .75 and the
Tax Multiplier is -MPC/1-MPC, the multiplier equals -3.
You increase taxes by $200 Billion or $600 divided by 3.
III. The Tax Multiplier for a Tax Decrease:
A. The formula for a tax decrease is: MPC/1-MPC (no negative sign)
The government can also have an effect on real GDP by changing taxes or
transfer payments. Tax increases or decreases also have a multiplied effect on
real GDP through circular flow. This is a fiscal policy tool for the federal
government to fight recession.
B. Application of the Tax Multiplier for a tax decrease:
If the MPC is .90 and the government decreases taxes by $20 Billion, what
is the multiplied effect on real GDP?
Tax Multiplier = MPC/1-MPC = .9/1-.9 = 9
The Multiplied Effect = 9 x $20 Billion = Positive $180 Billion
C. Closing an Recessionary Gap using a tax decrease:
The question becomes, if you intend to decrease taxes to speed up the
economy and close a Recessionary Gap, how much should taxes
decrease?
Example:
If there is a $600 Billion Recessionary Gap and the MPC is
.75, how much should taxes decrease to close the gap?
Answer:
Well, you don’t decrease taxes by $600
Billion. Considering the Circular Flow of the Economy,
that would overstimulate the economy and cause inflation.
How much do taxes need to decrease? Well if the MPC is
.75 and the Tax Multiplier is MPC/1-MPC, the multiplier
equals 3. You decrease taxes by $200 Billion or $600
divided by 3.
IV.
Balanced Budget Multiplier:
The government both collects taxes and spends revenue. In a simple model, the
dollars spent equal the dollars collected and the budget is balanced. We have
already looked at how the tax and spending multipliers are different. The
example below exhibits the balanced budget multiplier by using data from the
spending and tax multipliers above.
Balanced Budget Multiplier = 1
Why?
A $20 Billion increase in government spending results in an increase in real GDP
or $200 Billion, while a $20 Billion increase in taxes results in a decrease in real
GDP of $180 Billion. The net result is an increase in real GDP of $20B or 1 x the
increase in G. From a non-mathematical standpoint this is true because G is a
direct injection into circular flow while T is a leakage from circular flow. G has a
quicker impact on GDPr, while taxes have a delayed impact.