ModuleFiscal Policyand the Multiplier

KRUGMAN'SMACROECONOMICS for AP*

21

Margaret Ray and David Anderson

What you will learnin this Module:

•Why fiscal policy has a multiplier effect

•How the multiplier effect is influenced by automatic stabilizers

Multiplier Effects of an Increase in Government Purchases of Goods and Services

•Initial increase in spending•Government spends $200b. AD and RGDP increase by $200b

•Indirect effect of increased spending•The increase in government spending leads to increased incomes for consumers. This leads to an increase in AD and GDP also

•Remember the multiplier•1/1-MPC = Spending Multiplier•Spending multiplier x $200b = total change in AD and GDP

Multiplier Effects of Changes in Government Transfers and Taxes

Taxes and Transfers compared to Government Spending

•Transfer payments (unemployment insurance, TANF) change Consumption by the change in income x MPC•Tax cuts change Consumption by the change in income x MPC

The tax and transfer multiplier is MPC/MPS

Tax Multiplier

-4

-3

-1.5

-1

-9

Tax Multiplier = -MPC/MPSThis is negative if taxes increase

Spending Multiplier = 1/MPS

MPC Multiplier

9 10

.8 5

.75 4

.60 2.5

.5 2

The tax multiplier is always smaller than the spending multiplier because a portion of the

change in income due to taxes is saved, reducing the overall impact on spending.

How Taxes Affect the Multiplier

•The full multiplier effect assumes a constant level of taxes and transfer payments regardless of income level (lump-sum taxes)

•In reality taxes and transfer payments are based on income levels. •The effect is that the size of the multiplier is reduced and the economy is automatically stabilized.

• In contrast, discretionary fiscal policy would take place when Congress votes to make changes in taxes or government spending

Table 21.1 Hypothetical Effects of a Fiscal Policy with a Multiplier of 2Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition

Copyright © 2011 by Worth Publishers