fiscal policy & the multiplier chapter 12-2. fiscal policy & the multiplier fiscal policy...
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Fiscal Policy & The Fiscal Policy & The MultiplierMultiplier
Chapter 12-2Chapter 12-2
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Fiscal policy & The Multiplier 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.
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Multiplier Effects
• Every dollar of new government spending has a multiplied impact on aggregate demand.
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Multiplier Effects
• How much of a boost the economy gets depends on the value of the multiplier.
The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles.
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Multiplier Effects
• The total spending change equals the multiplier times the new spending injections.
Total change in spending = multiplier X new spending injection
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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
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Multiplier Effects
Real GDP ($ trillions per year)
Pric
e Le
vel (
aver
age
pric
e)
P1
5.6QE
5.8 6.4
AD2 AD3
Current price level
Direct impact of rise in government spending + $200 billion
AD1
ab
Indirect impact via increased consumption + $600 billion
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The Multiplier Effect of an The Multiplier Effect of an Increase in Government Purchases Increase in Government Purchases of Goods and Servicesof Goods and Services
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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.
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Taxes and Consumption
• Tax cuts directly increase the disposable income of consumers.
• The more important question is how does a tax cut affect spending.
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Taxes and Consumption
• The amount consumption increases depends on the marginal propensity to consume.
Initial increase in consumption = MPC X tax cut
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Taxes and Consumption*
• A tax cut contains lessless fiscal stimulus than an increase in government spending of the same size.
The initial spending injection is less than The initial spending injection is less than the size of the tax cut.the size of the tax cut.
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The Tax Cut Multiplier
First round of spending:
Second round of spending:
Third round of spending:
More income
More consumption
More income
More consumption
Tax Cut
More consumption= MPC X tax cut
More saving= MPS X tax cut
More saving
More saving
Cumulative change in saving: = tax cut
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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
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Fiscal Policy
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.
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How much will they spend?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?
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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.
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Who Gets The Tax Cut Matters*• It also matters WhoWho 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
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Automatic Stabilizers
• This is the Key word
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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.
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Building Fiscal Policies Into Institutions• Automatic stabilizers include welfare
payments, unemployment insurance, and the income tax system.
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Building Fiscal Policies Into Institutions• Automatic stabilizers include welfare
payments, unemployment insurance, and the income tax system.
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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.
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How Automatic Stabilizers Work• Government spending increase without
an explicit act by the government.
• When incomes increase, government spending declines automatically.
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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.
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Discretionary v. AutomaticRules 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.
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Differences in the Effect of Differences in the Effect of Expansionary Fiscal PoliciesExpansionary Fiscal Policies