Fiscal Policy & The Fiscal Policy & The MultiplierMultiplier

Chapter 12-2Chapter 12-2

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.

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.

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

Multiplier Effects

Real GDP ($ trillions per year)

Pric

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aver

age

pric

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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

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

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 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.

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

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

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?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 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

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. 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.

Differences in the Effect of Differences in the Effect of Expansionary Fiscal PoliciesExpansionary Fiscal Policies