Transcript 12-2

Fiscal Policy & The
Multiplier
Chapter 12-2
Fiscal policy & The
Multiplier
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Fiscal policy has a multiplier effect on the
economy.
Expansionary fiscal policy leads to an increase
in real GDP larger than the initial rise in
aggregate spending caused by the policy.
Conversely, contractionary fiscal policy leads to
a fall in real GDP larger than the initial
reduction in aggregate spending caused by the
policy.
Multiplier Effects
• Every dollar of new government spending
has a multiplied impact on aggregate
demand.
Multiplier Effects
• How much of a boost the economy gets
depends on the value of the multiplier.
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The multiplier is the multiple by which an
initial change in aggregate spending will alter
total expenditure after an infinite number of
spending cycles.
Multiplier Effects
• The total spending change equals the
multiplier times the new spending
injections.
Total change in spending = multiplier X
new spending injection
Multiplier Effects
• The impact of fiscal stimulus on
aggregate demand includes the new
government spending plus all subsequent
increases in consumer spending triggered
by the additional government outlays:
Increase in AD = multiplier X fiscal stimulus
Price Level (average price)
Multiplier Effects
Direct impact of rise
in government
spending + $200
billion
P1
Indirect impact via
increased consumption
+ $600 billion
a
b
AD1
5.6
QE
5.8
AD2
Current
price level
AD3
6.4
Real GDP
($ trillions per year)
The Multiplier Effect of an
Increase in Government Purchases
of Goods and Services
Tax Cuts
• By lowering taxes, the government
increases the disposable income of the
private sector.
– Disposable income is the after-tax income
of consumers; personal income less
personal taxes.
Taxes and Consumption
• Tax cuts directly increase the disposable
income of consumers.
• The more important question is how does
a tax cut affect spending.
Taxes and Consumption
• The amount consumption increases
depends on the marginal propensity to
consume.
Initial increase in consumption =
MPC X tax cut
Taxes and Consumption*
• A tax cut contains less fiscal stimulus
than an increase in government spending
of the same size.
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The initial spending injection is less than
the size of the tax cut.
The Tax Cut Multiplier
Tax Cut
First round of spending:
Second round of spending:
More consumption
= MPC X tax cut
More saving
= MPS X tax cut
More income
More saving
More consumption
More income
Third round of spending:
More saving
More consumption
Cumulative change in
saving: = tax cut
Increase in Transfer Payments
• Increasing transfer payments such as
social security, welfare, unemployment
benefits, and veterans’ benefits can
stimulate the economy.
• It works the same as a tax cut!
• It contain less of a fiscal stimulus than
Government Spending
Fiscal Policy
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The size of the shift of the aggregate demand curve
depends on the type of fiscal policy.
The multiplier on changes in government purchases,
1/(1 − MPC), is larger than the multiplier on changes
in taxes or transfers, MPC/(1 − MPC), because part
of any change in taxes or transfers is absorbed by
savings.
Changes in government purchases have a more
powerful effect on the economy than equal-sized
changes in taxes or transfers.
How much will they spend?
Ex: The government hands out $50 billion in the
form of tax cuts.
There is no direct effect on aggregate demand by
government purchases of goods and services;
GDP goes up only because households spend
some of that $50 billion.
How much will they spend?
How much?
MPC × $50 billion. For example, if MPC =
0.6, the first-round increase in consumer
spending will be $30 billion (0.6 × $50 billion
= $30 billion).
This initial rise in consumer spending will
lead to a series of subsequent rounds in
which real GDP, disposable income, and
consumer spending rise further.
Who Gets The Tax Cut
Matters*
• It also matters Who among the
population gets the tax cut or the transfer
payment.
• Different people have different MPC
• High income persons have a Lower MPC
• Low income persons have a Higher MPC
Automatic Stabilizers
• This is the Key word
Building Fiscal Policies Into
Institutions
• Economists have attempted to create
built-in fiscal policies.
• Automatic stabilizers – any government
program or policy that counteracts the
business cycle without any new
government action.
Building Fiscal Policies Into
Institutions
• Automatic stabilizers include welfare
payments, unemployment insurance, and
the income tax system.
Building Fiscal Policies Into
Institutions
• Automatic stabilizers include welfare
payments, unemployment insurance, and
the income tax system.
How Automatic Stabilizers
Work
• When the economy is in a recession, the
unemployment rate rises.
• Unemployment insurance automatically is
paid out to the unemployed, offsetting
some of the fall in income.
How Automatic Stabilizers
Work
• Government spending increase without
an explicit act by the government.
• When incomes increase, government
spending declines automatically.
How Automatic Stabilizers
Work
• When the economy expands, tax
revenues rise, slowing the economy.
• When the economy contracts, tax
revenues decline, providing stimulus to the
economy.
Discretionary v. Automatic
Rules governing taxes and some transfers
act as automatic stabilizers, reducing
the size of the multiplier and
automatically reducing the size of
fluctuations in the business cycle.
In contrast, discretionary fiscal policy
arises from deliberate actions by policy
makers rather than from the business
cycle.
Differences in the Effect of
Expansionary Fiscal Policies