Fiscal Policy & The Multiplier Chapter 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. l 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) Price Level (average price) P1P1 5.6 QEQE AD 2 AD 3 Current price level Direct impact of rise in government spending + $200 billion AD 1 a b Indirect impact via increased consumption + $600 billion

The Multiplier Effect of an Increase in Government Purchases of 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* lessA tax cut contains less fiscal stimulus than an increase in government spending of the same size. n The initial spending injection is less than the size of the tax cut.

The Tax Cut Multiplier First round of spending: Second round of spending: Third round of spending: More incomeMore consumptionMore incomeMore consumption Tax Cut More consumption = MPC X tax cut More saving = MPS X tax cut 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? 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* WhoIt also matters Who 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. Automatic Rules 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 Expansionary Fiscal Policies