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MODULE 21 Fiscal Policy and the Multiplier

MODULE 21 Fiscal Policy and the Multiplier. Why fiscal policy has a multiplier effect How the multiplier effect is influenced by automatic stabilizers. Using the Multiplier to Estimate the Influence of Government Policy.

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MODULE 21 Fiscal Policy and the Multiplier

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  1. MODULE 21Fiscal Policy and the Multiplier

  2. Why fiscal policy has a multiplier effect • How the multiplier effect is influenced by automatic stabilizers

  3. Using the Multiplier to Estimate the Influence of Government Policy • An expansionary fiscal policy pushes the aggregate demand curve to the right. But how much? • Fiscal policy has a multiplier effect on the economy. • Fiscal policy can take the form of changes in taxes, transfers, and government spending. • 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.

  4. Using the Multiplier to Estimate the Influence of Government Policy • The multiplier on changes in government purchases is 1/(1 − MPC). • For example, if the marginal propensity to consume is 0.5, the multiplier is 1/(1 − 0.5) = 1/0.5 = 2. • $50 billion increase in government purchases of goods and services would increase real GDP by how much? • $50 billion from change in initial investment and the additional $50 billion from the chain effect. • What happens if government purchases of goods and services are instead reduced, say, by $50 billion?

  5. Multiplier Effects of Changes in Taxes and Government Transfers • Example: 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? • 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.

  6. Multiplier Effects of Changes in Government Transfers and Taxes

  7. Multiplier Effects of Changes in Government Transfers and Taxes • The multiplier on changes in taxes or transfers is smaller because part of any change in taxes or transfers is absorbed by savings in the first round, which is not the case when government spends directly. • MPC is not same for everyone. Economists argue it depends on who is affected by the changes in tax. For instance, a dollar spent on unemployment benefits increases aggregate demand more than a dollar’s worth of dividend tax cuts. • When expansionary fiscal policy takes the form of a rise in transfer payments, real GDP may rise by either more or less than the initial government outlay • Changes in government purchases have a more powerful effect on the economy than equal-sized changes in taxes or transfers.

  8. How Taxes Affect the Multiplier • 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. • +Real GDP  + automatic gov. tax  - multiplier  contractionary policy, and vice versa. • In contrast, discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle.

  9. About That Stimulus Package . . . • The U.S. economy needed a fiscal stimulus. There was, however, sharp partisan disagreement about what form that stimulus should take. • Republicans favored tax cuts on general political principles. Democrats preferred transfer payments, especially increased unemployment benefits and expanded food stamp aid. • The eventual compromise gave most taxpayers a flat $600 rebate, $1,200 for married couples. • Many economists believed that only a fraction of the rebate checks would actually be spent, so that the eventual multiplier would be fairly low.

  10. Fiscal policy has a multiplier effect on the economy, the size of which depends upon the fiscal policy. • Except in the case of lump-sum taxes, taxes reduce the size of the multiplier. Expansionary fiscal policy leads to an increase in real GDP, while contractionary fiscal policy leads to a reduction in real GDP. • Because part of any change in taxes or transfers is absorbed by savings in the first round of spending, changes in government purchases of goods and services have a more powerful effect on the economy than equal-size changes in taxes or transfers.

  11. Rules governing taxes—with the exception of lump-sum 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. • Discretionaryfiscal policy arises from deliberate actions by policy makers rather than from the business cycle.

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