Chapter 13
Fiscal Policy
The Multiplier Formula (cont’d)
• Can use this formula to find the impact on
real GDP of any given change in
aggregate demand:
A change in any
Change in
m
component of AD
Real GDP
The Government Spending Multiplier
• Used to determine the change in government
spending needed to close a recessionary gap:
Size of the Recessionary Gap
Increase in

Government Spending
Basic Spending Multiplier
• Example: Suppose the government wants to close a
$0.5 trillion recessionary gap:

If the MPC = 0.9, the spending multiplier is 1 / (1–.09) = 10.

Thus, the required increase in government spending is
$0.5 trillion / 10 = $0.05 trillion ($50 billion).
The Tax Multiplier Process
• The government could also chose to lower
taxes to increase AD
• Tax cuts take longer to impact the economy.

Personal tax cuts:
• Must first increase disposable income
• Must be perceived as permanent

Business tax cuts:
• Must improve the profit outlook for businesses
• It takes time for investment to take place.
The Effect of Taxes on Household
Consumption
• The impact of personal tax cuts is diluted
because some of the additional
disposable income is saved.

Multiplier effect from a change in taxes < that
resulting from an equivalent change in
government spending.

The multiplier must also reflect the inverse
relation between taxes and changes in real
GDP. Tax Multiplier  (m 1)
The Tax Multiplier Equation
• Shows much taxes must decrease in
order to eliminate a given recessionary
gap:
Decrease Size of the Recessionary Gap

in taxes
Tax Multiplier
Where the Tax Multiplier = Basic Spending Multiplier 1
The Tax Multiplier Equation (cont’d)
• Example: Suppose the government plans to
close a $0.5 trillion recessionary gap using a
tax cut. Assume the MPC = 0.9.

The basic spending multiplier is 1 / (1–0.9) = 10.

The tax multiplier is 10 – 1 = 9.

The required tax cut is $0.5T / 9 = $0.055T.

Note that the required change in taxes is
larger than the required change in government
spending ($0.05T).
Can we do it? (number 5)
• Assuming an economy with full employment real
GDP of $600 billion, and an actual real GDP of
$500 billion, and a MPC = 0.9, answer the
following questions.




What type of gap exists in this economy?
What is the size of that gap?
To cure this gap using only changes in government
spending means that government spending must
(increase, decrease) by $ ___ billion
To cure this gap using only changes in taxes means
that taxes must (increase, decrease) by $ ___ billion
•
Recessionary gap
•
$100 billion
•
Increase
•
Decrease
100
 $10
1
1  .9
100
 $11.11
 1 

 1
 1  .9 
Contractionary Fiscal Policy (cont’d)
• Use of decreased government spending
and increased taxes to decrease both
aggregate demand and real GDP.
Figure 13.2 Curing the Overheating Economy
with Contractionary Fiscal Policy
Contractionary Fiscal Policy
• As a result of contractionary fiscal policy:

AD decreases.
• If AD decreases by the “right amount”, the
economy will move to the full employment level of
output.


The price level decreases.
The unemployment rate rises.
• Real GDP declines
Contractionary Fiscal Policy (cont’d)
• Example: Suppose the government wants
to close a $0.5 trillion expansionary gap:


If the MPC = 0.9, the spending multiplier is
1 / (1 – 0.9) = 10. Thus, the required decrease
in government spending is:
$0.5 trillion / 10 = $0.05 trillion ($50 billion).
The tax multiplier is 10 – 1 = 9, so the
required tax increase is $0.5T / 9 = $0.055T.