Module 21 Fiscal Policy and The Multiplier

Multiplier Effects of an Increase in Government Purchases of Goods and Services If consumption or Investment increases by $1, eventually that would multiply into more dollars of spending and income and real GDP. The size of the Multiplier depends on the Marginal Propensity to Consume or MPC. Spending Multiplier – 1/(1-MPC)

Multiplier Effects of an Increase in Government Purchases of Goods and Services An injection of government spending (G) works in t he same way. Example: Suppose the government is experiencing a recessionary gap. Current output if $500 billion below potential GDP (Y p) 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 =.90, the spending multiplier: – M = 1/.10 = 10

So an Increase of G = $50 billion will eventually multiply to a 10 x $50 billion = $400 billion positive shift of the AD to the right. Example: Suppose the government is experiencing an inflationary gap. Current output is $800 billion above potential GDP (Y p ) and inflation is starting to hurt the economy. If MPC =.75, M/(1 -.75) = 1/.25 = 4 So a decrease of G = $200 billion will eventually multiply to a 4 x $200 billion = $800 billion negative shift of the AD to the left.

Multiplier Effects of Changes in Government Transfers and Taxes Government can indirectly affect AD through taxes and transfers. But the impact of tax/transfer policy indirectly affects real GDP because this type of policy first affects consumer disposable in come (Y d ). 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.

Example: Suppose the government decides to lower income taxes by a limp-sum $1000. The MPC =.90 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 10 because M = 1/.90 = 10 So $1000 tax cut will eventually multiply into $9000 of additional real GDP.

Example: Suppose the government decides to increase transfer payments by a lump-sum of $500. The MPC =.80 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 5 because M = 1/.80 = 5. So a $500 increase of transfers will eventually multiply into $2000 of additional real GDP.

We can generalize that the tax multiplier Tm is less than the spending multiplier M. Tm = MPC X M = MPC/(1-MPC)

How Taxes Affect the Multiplier In reality, the eventual impact of discretionary fiscal policy is lessened by the progressive tax system. Assume the economy is in recession and the government has increased G to boost employment and real GDP. AS some consumers find jobs and increased income, they start paying more taxes and disposable income falls. As Y d falls, it slows down the multiplier process. This may avoid a situation where the big shift in AD creates inflation. The progressive tax system is a form of automatic stabilizer.

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.