FISCAL POLICY &
THE MULTIPLIER
OBJECTIVES:
Why fiscal policy has a multiplier
effect?
How is the multiplier effect is
influenced by automatic stabilizers?
MULTIPLIER EFFECTS OF AN
INCREASE IN GOVERNMENT
PURCHASES OF GOODS AND
SERVICES
Government spends
$50 billion building
bridges & roads
Rise in consumer
spending will induce
firms to increase
output, leading to a
further rise in
disposable income
Government’s purchase
will increase total
spending on final goods
and services by $50
billion
Chain reaction
begins
Increase in
disposable income
will lead to a rise in
consumer spending
Firms producing goods &
services purchased by the
government will earn revenues
that flow to households in the
form of wages, profit, interest,
and rent
MULTIPLIER EFFECTS
 Multiplier is the ratio of the change in real GDP
caused by an autonomous change in aggregate
spending to the size of the autonomous change
 Example:
 increase in government purchases of goods and services is a
autonomous increase in aggregate spending
 Any change in government purchase of goods and services will
lead to an even greater change in read GDP
 Chain reaction causes the initial change in government purchased
to multiple through the economy
MULTIPLIER EFFECTS
 Example with no taxes or international trade
 Aggregate price level is fixed, so any increase in nominal GDP
is also a rise in read GDP and the interest rate is fixed
 Multiplier is 1/(1-MPC)
 MPC = marginal propensity to consume (the fraction of an additional
dollar in disposable income is spent)
 MPC = 0.5
 Multiplier is 1/(1-0.5)= 1/0.5 = 2
 $50 billion increase in government purchases of goods or
services would increase real GDP by $100 billion
MULTIPLIER EFFECTS
 MPC = 0.5
 Multiplier is 1/(1-0.5)= 1/0.5 = 2
 $50 billion increase in government purchases of goods or services
would increase real GDP by $100 billion
 Of that $100 billion, $50 billion is the initial effect from the
increase in G, and the remaining $50 billion is the subsequent
effect of more production leading to a more income which leads
to more consumer spending, which leads to more production…….
 If the government purchases of goods and services are reduced,
all the math stays the same with the exception of a minus sign in
front
MULTIPLIER EFFECTS OF CHANGES
IN GOVERNMENT TRANSFERS &
TAXES
A change in government transfers or taxes
shifts the aggregate demand curve by less
than an equal-sixed change in government
purchases, resulting in a smaller effect on
real GDP
MULTIPLIER EFFECTS OF CHANGES
IN GOVERNMENT TRANSFERS &
TAXES
 Hypothetical comparison of two expansionary fiscal
policies assuming an MPC = 0.5 and a multiplier= 2
MULTIPLIER EFFECTS OF CHANGES
IN GOVERNMENT TRANSFERS &
TAXES
 Overall, 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—the multiplier may
either be more or less than 1
 Tax cut has a similar effect to the effect of a transfer
 Increases disposable income, leading to a series of increases in consumer
spending
 Overall effect is smaller than that of an equal-sized increase in
government purchases of goods and services
 The autonomous increase in aggregate spending is smaller because
households save part of the amount of the tax cut – MPS (1-MPC)
MULTIPLIER EFFECTS OF CHANGES
IN GOVERNMENT TRANSFERS &
TAXES
 Taxes typically change the size of the multiplier
 Lump-sum taxes are the amount of tax a household
owes that is independent of its income
 The great majority of tax revenue is raised via taxes
that depending positively on the level of real GDP
ABOUT THAT STIMULUS PACKAGE . . .
 In early 2008 there was broad bipartisan agreement that 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, by contrast, 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. How well designed was the
stimulus plan?
 Many economists believed that only a fraction of the rebate
checks would actually be spent, so that the eventual multiplier
would be fairly low.
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
 Most government taxes depend positively on real GDP
 Disposable income increases by considerably less than $1
once we includes taxes
 Increase in government tax revenue when real GDP rises
isn’t the result of a deliberate decision or action by the
government – it’s a consequence of the way the tax laws
are written
 Which causes most sources of government revenue to increase
automatically when real GDP goes
HOW TAXES AFFECT THE
MULTIPLIER
 Effect of automatic increases in tax revenue is to reduce the
size of the multiplier
 Remember – the multiplier is the result of a chain reaction in
which higher real GDP leads to further increases in real GDP
 Many macroeconomists believe it’s a good thing that in real life
taxes reduce the multiplier
 Most (not all) recessions are the result of negative demand shocks
HOW TAXES AFFECT THE
MULTIPLIER
 Automatic stabilizers are government spending and
taxation rules that cause fiscal policy to be
automatically expansionary when the economy
contracts and automatically contractationary when
the economy expands
 The rules that govern tax collection aren't the only
automatic stabilizers
 Some types of government transfers such as unemployment
insurance, Medicaid and food stamps
HOW TAXES AFFECT THE
MULTIPLIER
 What about fiscal policy that isn’t the result of
automatic stabilizers?
 Discretionary fiscal policy is fiscal policy that is the
result of deliberate actions by policy makers rather
than rules
 Example:
 During a recession, the government may pass legislation that cuts
taxes and increases government spending in order to stimulate
the economy