Module 21
Fiscal Policy and The Multiplier
Multiplier Effects of an Increase in
Government Purchases of Goods and
Services
• If consumption or Investment increases by $1,
eventually that would multiply into more
dollars of spending and income and real GDP.
• The size of the Multiplier depends on the
Marginal Propensity to Consume or MPC.
• Spending Multiplier – 1/(1-MPC)
Multiplier Effects of an Increase in
Government Purchases of Goods and
Services
• An injection of government spending (G) works in
t he same way.
• Example: Suppose the government is
experiencing a recessionary gap.
• Current output if $500 billion below potential GDP
(Yp) and unemployment is beginning to rise.
• Does the government need to inject $500 of new
G into the economy to return to full employment?
No
• If MPC = .90, the spending multiplier:
– M = 1/.10 = 10
• So an Increase of G = $50 billion will eventually
multiply to a 10 x $50 billion = $400 billion
positive shift of the AD to the right.
• Example: Suppose the government is
experiencing an inflationary gap.
• Current output is $800 billion above potential
GDP (Yp) and inflation is starting to hurt the
economy.
• If MPC = .75, M/(1 -.75) = 1/.25 = 4
• So a decrease of G = $200 billion will eventually
multiply to a 4 x $200 billion = $800 billion
negative shift of the AD to the left.
Multiplier Effects of Changes in
Government Transfers and Taxes
• Government can indirectly affect AD through
taxes and transfers.
• But the impact of tax/transfer policy indirectly
affects real GDP because this type of policy
first affects consumer disposable in come (Yd).
• Consumers will save some of every new dollar
of Yd.
• If dollars of new Yd are saved, they cannot
multiply into additional spending and income.
• Example: Suppose the government decides to
lower income taxes by a limp-sum $1000.
• The MPC = .90
• When Americans get $1000 back into their
pockets, they will save $100 (10%) and spend
$900 (90%)
• $900 of new spending will now multiply by a
factor of 10 because M = 1/.90 = 10
• So $1000 tax cut will eventually multiply into
$9000 of additional real GDP.
• Example: Suppose the government decides to
increase transfer payments by a lump-sum of
$500.
• The MPC = .80
• When Americans receive $500 more disposable
income, they will save $100 (20%) and spend
$400 (80%).
• $400 of new spending will now multiply by a
factor of 5 because M = 1/.80 = 5.
• So a $500 increase of transfers will eventually
multiply into $2000 of additional real GDP.
• We can generalize that the tax multiplier Tm
is less than the spending multiplier M.
• Tm = MPC X M = MPC/(1-MPC)
How Taxes Affect the Multiplier
• In reality, the eventual impact of discretionary fiscal
policy is lessened by the progressive tax system.
• Assume the economy is in recession and the government
has increased G to boost employment and real GDP.
• AS some consumers find jobs and increased income,
they start paying more taxes and disposable income falls.
• As Yd falls, it slows down the multiplier process.
• This may avoid a situation where the big shift in AD
creates inflation.
• The progressive tax system is a form of automatic
stabilizer.
Automatic Stabilizers
• 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.
• This is also called “non-discretionary” fiscal
policy.