Review Spending Multiplier Remember if C or I
Review Spending Multiplier • Remember, if C or I increased 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 Effect of an Increase in Government Purchases of Goods and Services • • • If MPC is. 90: 1/(1 -MPC) 1/(1 -. 90) Then, the Multiplier = 10 An “injection” of government spending works the same way.
Suppose the government is experiencing a recessionary gap • The government wouldn’t just “inject” a certain amount into the economy to bring it back to equilibrium. • If current output is $500 below potential GDP, and unemployment is beginning to rise, what could they do? • A $50 billion increase in government spending would have what impact on the recessionary gap?
• If the Spending Multiplier is 10, an increase of Government spending by $50 billion will eventually multiply to a • 10 X 50 Billion = $500 Billion Positive shift of the AD curve to the right.
Multiplier Effects of Changes in Government Transfers and Taxes • How Taxes affect the Multiplier: • In reality, the eventual impact of discretionary fiscal policy (fiscal policy that is the result of deliberate actions by policy makers rather than rules) is lessened by the progressive tax system.
• Assume the economy is in a 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 Yd falls, it slows down the multiplier process. This may avoid a situation where the Big Shift in AD creates inflation
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
Answer: • Because the economy is suffering from inflation, taxes need to be raised or transfers need to be cut. • The tax multiplier Tm =. 75/(1 -. 75) = 3 • To reduce real GDP by $600 billion, taxes need to be increased (or transfers need to be decreased) by $600 billion/3 = $200 Billion • Tax Multiplier: MPC/(1 -MPC)
- Slides: 8