1. Fiscal Policy: Multiplier Effect

2. Learning Objectives
Upon completing the assignment, students will understand how:
Fiscal policy – both government spending and tax policies – can affect aggregate demand
The multiplier is calculated and how it works over time

3. Learning Objectives (cont.)
The marginal propensity to consume (MPC) relates to the multiplier effect
The government spending multiplier differs from the tax multiplier
The crowding-out effect dampens the shift in aggregate- demand

4. Two Fiscal Policy Tools
The government has two fiscal policy tools it can use to influence the behavior of the economy:
Government purchases
Taxes

5. Two Fiscal Policy Tools (cont.)
Government purchases directly affect the overall economy. If the government increases spending on goods and services, it directly increases aggregate demand.
Changes to tax levels indirectly affect the overall economy by affecting consumer spending. For example, after a tax cut people have more money to spend, therefore increasing total consumption.

6. The Multiplier Effect
How much does the aggregate demand increase after an increase in government spending or a tax cut?
The multiplier is used to show how the economy amplifies the impact of an initial change in spending.
An initial change in spending will set off a chain- reaction of spending throughout the economy.

7. The Multiplier Effect (cont.)
These repeated rounds of spending, although diminishing in each round, will accumulate and result in an amplified change in GDP.
The multiplier is used to calculate the additional shifts in aggregate demand that result after an initial increase in income due to expansionary fiscal policy.

8. The Multiplier
The multiplier amplifies the effect of fiscal policy on aggregate demand: (Multiplier) X (Initial Change in Demand) = Change in GDP For example, if the multiplier = 4, and government increased spending by $20 billion, then: 4 X $20 billion = $80 billion in aggregate demand

9. Increase in Aggregate Demand
The multiplier effect pushes the AD curve further out to the right in response to the initial increase in demand.
Price
Level
Increase in government spending = initial increase in aggregate demand.
AD3
Aggregate
Demand AD1
AD2
Quantity of Output

10. Marginal Propensity to Consume
To calculate the multiplier you must know the Marginal Propensity to Consume (MPC).
The MPC is simply the fraction of extra income a household consumes rather than saves. In other words, when given an extra dollar, what percentage of that dollar would a household spend as opposed to save.

11. Marginal Propensity to Consume (cont.)
For example, economists estimate the current MPC for the U.S. at approximately .97. This indicates out of every extra $100, the average household would spend $97 and save $3.
The size of the MPC is important for determining how much money will eventually go back into the economy during each of the repeated rounds of spending after an initial increase in income.

12. Calculating the Government Spending Multiplier
The marginal propensity to consume (MPC) is used to calculate the multiplier.
The government
spending multiplier 1 =
(1 - MPC)

13. Calculating the Tax Multiplier
The tax multiplier formula differs from the government spending multiplier, as it takes into account that lowering taxes is not the same as injecting new money into the economy.
Depending on the MPC, households will spend some portion of their extra disposable income after a tax cut.
Because “subtracting” taxes increases income (and vice versa), the tax multiplier is negative.
- MPC
Tax Multiplier =
(1 - MPC)

14. The Crowding Out Effect
While the multiplier amplifies the effect of expansionary fiscal policy, crowding out can have a dampening effect.
The government sale of bonds to finance purchases can raise interest rates and crowd out private investment. Less investment means less aggregate demand.
Likewise, when the government cuts taxes (leading to higher income) this in turn leads to a higher demand for money and raises interest rates. Again, private investment is crowded out.

15. The Crowding Out Effect (cont.)
This crowding out effect will offset some of the total expansionary effect of the multiplier on the GDP.
Crowding out tends to be applicable to structural deficits, not cyclical deficits. (In cyclical deficits, recession causes a decline in the demand for money, leading to lower interest rates.)

16. Aggregate Demand: Crowding Out
The crowding out effect partially dampens the effect of the multiplier on the increase in aggregate demand.
Price
Level
Increase in government spending along with the multiplier effect increases aggregate demand.
AD2
AD3
Aggregate
Demand AD1
Quantity of Output

17. Assignment
Click Link to Platform or access the tool at: classroom.wharton.upenn.edu/econmult/
Government Spending should be selected by default.

18. Assignment (cont.)
In this exercise, the government has decided to increase government spending by $20 MM. Type 20 in the I field to indicate the initial increase in demand.
For now, leave the MPC at the default (0.9).
Click Run Rounds.

19. Assignment
Note the diminishing rounds of spending by using the Next button in the data table to page through until the Incremental Demand drops to 0.

20. Assignment (cont.)
Note that the total change in demand is the result of the initial change in government spending times the multiplier.
Change the MPC to Leave the initial increase at $20 MM and click Run Rounds. How much has total demand decreased or increased?

21. Assignment (cont.) Change Government Spending to Taxation.
Leave the values for I and MPC the same and click Run Rounds. Note that the initial demand is a negative number, indicating that the government has issued a $20 MM tax cut.

22. Assignment (cont.)
Note that the tax cut is an indirect method of increasing demand, therefore the initial round of spending is 0.
Finally, recall the total increase in demand from the $20 MM increase in government spending. Compare that sum with the total demand generated from the $20 MM tax cut.

23. Conclusion
The government can use fiscal policy--changing government spending and/or changing taxes--to influence the behavior of the overall economy.
The multiplier effect refers to the phenomenon that an initial change in spending will result in a level of total income that is greater than the initial change in expenditure.

24. Conclusion (cont.)
The size of the multiplier depends upon the marginal propensity to consume (MPC); the MPC is the percentage of a change in income that would be spent on consumption instead of being saved.
The crowding out effect can reduce some of the economic expansion achieved by the multiplier.