FISCAL POLICY THE MULTIPLIER OBJECTIVES Why fiscal policy

FISCAL POLICY & THE MULTIPLIER

OBJECTIVES: Why fiscal policy has a multiplier effect? How is the multiplier effect is influenced by automatic stabilizers?

MULTIPLIER EFFECTS OF AN INCREASE IN GOVERNMENT PURCHASES OF GOODS AND SERVICES

Government spends $50 billion building bridges & roads Rise in consumer spending will induce firms to increase output, leading to a further rise in disposable income Increase in disposable income will lead to a rise in consumer spending Government’s purchase will increase total spending on final goods and services by $50 billion Chain reaction begins Firms producing goods & services purchased by the government will earn revenues that flow to households in the form of wages, profit, interest, and rent

MULTIPLIER EFFECTS Multiplier is the ratio of the change in real GDP caused by an autonomous change in aggregate spending to the size of the autonomous change Example: increase in government purchases of goods and services is a autonomous increase in aggregate spending Any change in government purchase of goods and services will lead to an even greater change in read GDP Chain reaction causes the initial change in government purchased to multiple through the economy

MULTIPLIER EFFECTS Example with no taxes or international trade Aggregate price level is fixed, so any increase in nominal GDP is also a rise in read GDP and the interest rate is fixed Multiplier is 1/(1 -MPC) MPC = marginal propensity to consume (the fraction of an additional dollar in disposable income is spent) MPC = 0. 5 Multiplier is 1/(1 -0. 5)= 1/0. 5 = 2 $50 billion increase in government purchases of goods or services would increase real GDP by $100 billion

MULTIPLIER EFFECTS MPC = 0. 5 Multiplier is 1/(1 -0. 5)= 1/0. 5 = 2 $50 billion increase in government purchases of goods or 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 a more income which leads to more consumer spending, which leads to more production……. If the government purchases of goods and services are reduced, all the math stays the same with the exception of a minus sign in front

MULTIPLIER EFFECTS OF CHANGES IN GOVERNMENT TRANSFERS & TAXES A change in government transfers or taxes shifts the aggregate demand curve by less than an equal-sixed change in government purchases, resulting in a smaller effect on real GDP

MULTIPLIER EFFECTS OF CHANGES IN GOVERNMENT TRANSFERS & TAXES Hypothetical comparison of two expansionary fiscal policies assuming an MPC = 0. 5 and a multiplier= 2

MULTIPLIER EFFECTS OF CHANGES IN GOVERNMENT TRANSFERS & TAXES Overall, when expansionary fiscal policy takes the form of a rise in transfer payments, real GDP may rise by either more or less than the initial government outlay—the multiplier may either be more or less than 1 Tax cut has a similar effect to the effect of a transfer Increases disposable income, leading to a series of increases in consumer spending Overall effect is smaller than that of an equal-sized increase in government purchases of goods and services The autonomous increase in aggregate spending is smaller because households save part of the amount of the tax cut – MPS (1 -MPC)

MULTIPLIER EFFECTS OF CHANGES IN GOVERNMENT TRANSFERS & TAXES Taxes typically change the size of the multiplier Lump-sum taxes are the amount of tax a household owes that is independent of its income The great majority of tax revenue is raised via taxes that depending positively on the level of real GDP

ABOUT THAT STIMULUS PACKAGE. . . In early 2008 there was broad bipartisan agreement that the U. S. economy needed a fiscal stimulus. There was, however, sharp partisan disagreement about what form that stimulus should take. Republicans favored tax cuts on general political principles. Democrats, by contrast, preferred transfer payments, especially increased unemployment benefits and expanded food stamp aid. The eventual compromise gave most taxpayers a flat $600 rebate, $1, 200 for married couples. How well designed was the stimulus plan? Many economists believed that only a fraction of the rebate checks would actually be spent, so that the eventual multiplier would be fairly low.

HOW TAXES AFFECT THE MULTIPLIER Government taxes capture some part of the increase in real GDP that occurs in each round of the multiplier process Most government taxes depend positively on real GDP Disposable income increases by considerably less than $1 once we includes taxes Increase in government tax revenue when real GDP rises isn’t the result of a deliberate decision or action by the government – it’s a consequence of the way the tax laws are written Which causes most sources of government revenue to increase automatically when real GDP goes

HOW TAXES AFFECT THE MULTIPLIER Effect of automatic increases in tax revenue is to reduce the size of the multiplier Remember – the multiplier is the result of a chain reaction in which higher real GDP leads to further increases in real GDP Many macroeconomists believe it’s a good thing that in real life taxes reduce the multiplier Most (not all) recessions are the result of negative demand shocks

HOW TAXES AFFECT THE MULTIPLIER Automatic stabilizers are government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractationary when the economy expands The rules that govern tax collection aren't the only automatic stabilizers Some types of government transfers such as unemployment insurance, Medicaid and food stamps

HOW TAXES AFFECT THE MULTIPLIER What about fiscal policy that isn’t the result of automatic stabilizers? Discretionary fiscal policy is fiscal policy that is the result of deliberate actions by policy makers rather than rules Example: During a recession, the government may pass legislation that cuts taxes and increases government spending in order to stimulate the economy