Download Fiscal Policy and the multiplier

FISCAL POLICY AND
THE MULTIPLIER
Multiplier Effect of Increasing Government
Purchases
• Government spending is an autonomous increase in aggregate
spending
• This additional initial spending will start a chain reaction
throughout the economy
• This initial spending multiplied by the multiplier gives us the
final change in real GDP
Ex 1: If the MPC is 0.5, the multiplier is __.
2 M = 1/(1-0.5) = 2
Given a multiplier of 2, a $50 billion increase in government
purchases of goods and services would increase real GDP by
$100 billion
__________.
Of that $100 billion, $50 billion is the initial effect from the
increase in G, and the remaining $50 billion is the subsequent
effect of more production leading to more income which leads to
more consumer spending, which leads to more production, and
so on.
G Multiplier
Ex 2: Suppose the US is experiences a recessionary gap.
Current output is $500 billion below potential GDP and
unemployment is beginning to rise. Does the
government need to inject $500 of new G into the
economy to return to full employment? NO
If MPC=0.9, what is the government spending multiplier?
M = 1/.10 = 10
So an increase of G = $50 billion will eventually multiply to
a 10=$50 billion = $500 billion positive shift of AD to the
right.
G Multiplier
Ex 2: Suppose the US is experiences an inflationary gap.
Current output is $800 billion above potential GDP and
inflation is starting to hurt the economy.
If MPC=0.75, what is the government spending multiplier?
M = 1/.25 = 4
So a decrease of G=$200 billion will eventually multiply to
a 4=$200 billion = $800 billion negative shift of AD to the
left.
Multiplier Effect of Changes in
Government Transfers & Taxes
• Government can indirectly affect AD
through taxes and transfers.
• The impact of tax/transfer policy indirectly
affects real GDP because this type of policy first
affects consumer disposable income (Yd)
• Consumers will save some of every new dollar
of Yd
• If dollars of new Yd are saved, they cannot
multiply into additional spending and income
Government Transfers Multiplier
Ex 1: Suppose the government decides to lower income
taxes by a lump-sum $1000.
The MPC is 0.9.
When Americans get $1000 back into their pockets, they
will save $100 (10%) and spend $900 (90%).
$900 of new spending will now multiply by a factor of __?
M= 1/1-.9 = 10
So $1000 tax cut will eventually multiply into $9000 of
additional real GDP.
Government Transfers Multiplier
Ex. Suppose the government decides to increase transfer
payments by a lump-sum $500.
The MPC is 0.8.
When Americans receive $500 more disposable income,
they will save $100 (20%) and spend $400 (80%).
$400 of new spending will now multiply by a factor of __?
M= 1/1-.8 = 5
So $500 tax cut will eventually multiply into $2000 of
additional real GDP.
Taxes and the Multiplier
• Taxes capture part of the increase in real GDP
• As a result of tax structure, government revenue
increases when real GDP does
• Effects of these automatic increases in tax revenue
reduce the size of the multiplier
• We can generalize that the tax multiplier (Tm) is less than
the spending multiplier (M)
• Tm = - MPC/(1-MPC)
Types of
Government Stabilizers
• Automatic stabilizers: government spending and taxation
rules that cause fiscal policy to be automatically
expansionary when the economy contracts and
automatically contractionary when the economy expands,
without requiring any deliberate action by policy makers
• This is also called “non-discretionary” fiscal policy
• The progressive tax system is a form of an automatic stabilizer
• Some government transfers are also automatic stabilizers
• Discretionary fiscal policies: active stabilization policies
• Results in deliberate action by policy makers rather than rules
• Because of problems with time lags, discressionary fiscal policy is
used only in special circumstances, such as a severe recession
Extra Practice
1. Real GDP is currently $600 billion above potential GDP
and price inflation is beginning to dominate the headlines.
How could the government adjust taxes or transfers to
return the economy to full employment? How large would
this lump-sum adjustment need to be? Assume the
MPC=.75
Extra Practice
2. Current real GDP is $6 trillion and potential GDP is $7.5
trillion. The government is prepared to pass a spending
package to return the economy to full employment. What
kind of spending package should be passed and how big
does it need to be? Assume the MPC = 0.9