USING THE MULTIPLIER TO ESTIMATE THE INFLUENCE OF GOVERNMENT POLICY Expansionary fiscal policy shifts the AD curve to the right, and contractionary fiscal policy shifts the AD curve to the left. However, just knowing the direction of the shift is not enough, policy makers need estimates of how much the AD curve is shifted by a given policy. In order to get these estimates, the policy makers use the concept of the multiplier.
MULTIPLIER EFFECTS OF AN INCREASE IN GOVERNMENT SPENDING The government’s purchases of goods and services starts a chain reaction throughout the economy. Households Government Firms Earn receive income Spending Revenues (wages, profit, interest, and rent This increase in disposable income will lead to a rise in consumer spending, which induces firms to increase output, leading to a further rise in disposable income, which will lead to another round of consumer spending increases, and so on…
MULTIPLIER EFFECTS OF AN INCREASE IN GOVERNMENT SPENDING This effect is due to the multiplier: the ratio of the change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous spending. Therefore, any change in government spending will lead to an even greater change in real GDP. The initial change in spending, multiplied by the multiplier, will give us the final change in real GDP. A reduction in government spending will have the same effect, but with a negative sign, reducing real GDP more than the initial change in spending.
MULTIPLIER EFFECTS OF CHANGES IN GOVERNMENT TRANSFERS AND TAXES Expansionary or contractionary fiscal policy is not only undertaken by changing government spending. Governments can also change transfer payments or taxes. However, a change in government transfers or taxes shifts the AD curve by less than an equal-size change in government purchases, which results in a smaller effect on real GDP. In the case of transfer payments, households will only spend a part of the additional income received (the MPC) and save part (the MPS).
HYPOTHETICAL EFFECTS OF A FISCAL POLICY WITH A MULTIPLIER OF 2 $50 BILLION RISE IN $50 BILLION RISE IN GOVERNMENTEFFECT ON REAL GDP GOVERNMENT PURCHASES OF TRANSFER PAYMENTS GOODS AND SERVICES FIRST ROUND $50 BILLION $25 BILLION SECOND ROUND $25 BILLION $12.5 BILLION THIRD ROUND $12.5 BILLLION $6.25 BILLION … … … EVENTUAL EFFECT $100 BILLION $50 BILLION
MULTIPLIER EFFECTS OF CHANGES IN GOVERNMENT TRANSFERS Overall, when expansionary fiscal polity 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 be either more or less than 1). If a smaller share of the initial transfer has been spent, the multiplier on that transfer would be less than 1; if a larger share of that initial transfer is spent, the multiplier would be more than 1.
MULTIPLIER EFFECTS OF CHANGES IN GOVERNMENT TAXES A tax cut has an effect similar to the effect of a transfer: it increases disposable income, leading to a series of increases in consumer spending. However, the overall effect is smaller than that of an equal-size increase in government spending. This autonomous increase in aggregate spending is smaller because households save part of the amount of a tax cut (the MPS).
MULTIPLIER EFFECTS OF CHANGES IN GOVERNMENT TAXES Taxes introduce a further complication: they typically change the size of the multiplier. In the real world, government rarely impose a lump- sum tax (in which the amount of a tax a household owes is independent of its income). Instead, tax revenue is raised via taxes that depend positively on the level of real GDP, which reduce the size of the multiplier.
MULTIPLIER EFFECTS OF CHANGES IN GOVERNMENT TAXES Economists argue that it also matters who gets the tax cuts or increases in government transfers. A dollar spent on unemployment benefits increases AD more than a dollar’s worth of dividend tax cuts, as people with lower incomes tend to spend a higher share of any increase in disposable income and wealthier people tend to save more of any increase in disposable income.
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, since most government taxes depend positively on real GDP. Therefore, disposable income increases by considerable less than $1 once taxes are included in the model. The increase in government tax revenue when GDP rises is not a deliberate action of the government; it is a consequence of the way tax laws are written. Sources of government revenue increase automatically when real GDP increases.
TAXES AS AUTOMATIC STABILIZERS Income tax receipts increase when real GDP rises because the amount each individual owes in taxes depends positively on income, and households’ income rises when real GDP rises. Sales tax receipts increase when real GDP rises because consumption increases and people buy more goods and services. Corporate profit tax receipts increase when real GDP rises because profits increase when the economy expands.
TAXES AS AUTOMATIC STABILIZERS The effect of these automatic increases in revenue is to reduce the size of the multiplier. Since the government takes away some of the increase in real GDP (in the form of taxes) at each successive round of spending, the increase in consumer spending is smaller than it would be if taxes weren’t part of the process. The result of this is to reduce the multiplier.
TAXES AS AUTOMATIC STABILIZERS The same mechanism that causes tax revenue to increase when real GDP rises causes it to fall when the economy contracts, so the effects of the negative demand shocks are smaller than they would be if there were no taxes. The decrease in tax revenue reduces the negative effect of the initial fall in AD. This automatic decrease in government tax revenue caused by a fall in real GDP (caused by a decrease in the amount of taxes households pay) acts like an automatic expansionary fiscal policy: a decrease in taxes.
TAXES AS AUTOMATIC STABILIZERS The automatic increase in government tax revenue caused by a rise in real GDP (caused by an increase in the amount of taxes households pay) acts like an automatic contractionary fiscal policy: an increase in taxes. Government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands, without requiring any deliberate action by policy makers, are called automatic stabilizers.
OTHER AUTOMATIC STABILIZERS These rules that govern tax collection are not the only automatic stabilizers, but they are the most important ones. Transfer payments tend to rise when the economy is contracting and fall when the economy is expanding. Like changes in tax revenue, automatic changes in transfers tend to reduce the size of the multiplier because the total change in disposable income that results from a given rise or fall in real GDP is smaller.
DISCRETIONARY FISCAL POLICY Discretionary fiscal policy is fiscal polity that is the direct result of deliberate actions by policy makers, rather than automatic adjustments Generally, due to time lag problems, economist tend to support the use of discretionary fiscal policy only in special circumstances. The size of automatic stability depends on responsiveness of changes in taxes to changes in GDP: The more progressive the tax system, the greater the economy’s built in stability Automatic stability reduces instability, but does not correct economic instability.
EXERCISE (CONT.)a) Graph this consumption schedule, and determine the size of the MPC.b) Assume a lump sum (regressive) tax of $10 billion is imposed at all levels of GDP. Calculate the tax rate at each level of GDP. Graph the resulting consumption schedule, and compare the MPC and the multiplier with those of the pre-tax consumption schedule.c) Now suppose a proportional tax with a 10 percent tax rate is imposed instead of the regressive tax. Calculate and graph the new consumption schedule and note the MPC and the multiplier
EXERCISE (CONT.)d) Finally, impose a progressive tax such that the tax rate is 0% when GDP is $100, 5% at $200, 10% at $300, 15% at $400, and so forth. Determine and graph the new consumption schedule, noting the effect of this tax system on the MPC and the multiplier.e) Explain why proportional and progressive taxes contribute to greater economic stability, while a regressive tax does not. Demonstrate using a graph.
EXERCISE PART d) GDP, Tax, DI, Consumptio Tax rate, MPCbillions billions billions n after tax percent $100 $0 $100 $120 0% undefined 200 10 190 192 5 0.72 300 30 270 256 10 0.64 400 60 340 312 15 0.56 500 100 400 360 20 0.48 600 150 450 400 25 0.40 700 210 490 432 30 0.32• The MPC decreases, so the multiplier changes.• Proportional and (especially) progressive tax systems reduce the size of MPC and therefore, the size of the multiplier.• A lump sum tax does not change the MPC or the multiplier.