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National Income and Price Determination: Fiscal Policy and the Multiplier AP Economics Mr. Bordelon S Multiplier Effects of Change in Government Purchases G/S S If C or I increased by $1, eventually that would multiply into more dollars of spending and income and real GDP. The size of the multiplier depends on the MPC. S Spending multiplier = 1/(1 – MPC) S An injection of government spending (G) works the same way. Multiplier Effects of Change in Government Purchases G/S S Example. Suppose government is experiencing recessionary gap. Current output is $500 billion below 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? S No! In solving these problems, it helps to draw out the basic scenario with an AD/AS model. S MPC = 0.9, M = 1/(1 – 0.9) = 1/0.1 = 10 S An increase of G by $50 billion would mean a tenfold effect— 10 x $50 billion = $500 billion positive AD shift to the right. Multiplier Effects of Change in Government Purchases G/S S Example. Suppose government is experiencing inflationary gap. Current output is $800 billion above YP and inflation is hurting the economy. S MPC = 0.75, M = 1/(1 – 0.75) = 1/0.25 = 4 S A decrease of G by $200 billion will mean a decrease by 4— 4 x $200 billion = $800 billion negative AD shift to the left. Multiplier Effects of Change in Government Transfers and Taxes S Government can indirectly affect AD through taxes and transfers. S The impact of tax/transfer policy indirectly affects real GDP because this type of policy first affects consumer YD. S Consumers will save some of every new dollar of YD. S If dollars of new YD are saved, they can not multiply into additional spending and income. Multiplier Effects of Change in Government Transfers and Taxes S Example. Suppose government decides to lower income taxes by a lump-sum $1000. MPC = 0.9. S When Americans get $1000 back into their pockets, they will save $100 (10%) and spend $900 (90%). S $900 of new spending will now multiply by 10. S M = 1/(1 – 0.9) = 1/0.1 = 10 S $1000 tax cut will multiply into $9000 additional real GDP. Multiplier Effects of Change in Government Transfers and Taxes S Example. Suppose government decides to increase income taxes by a lumpsum $1000. MPC = 0.8. S S When Americans lose that $1000, they will cut back their spending by $800 (80%) and savings by $200 (20%). $800 lost will now be multiplied by 5 S S M = 1/(1 – 0.8) = 1/0.2 = 5 $1000 tax increase will multiply into $4000 additional real GDP lost. S Wait, what? That doesn’t seem to account for taxes. S Actually, Ryan and Kyle, it does. Remember, we took the $200 out already. S But Mr. Bordelon, isn’t there a way we could just calculate it directly without having to do the song and dance of MPC/MPS? S Yes, Ryan and Kyle, there is Multiplier Effects of Change in Government Transfers and Taxes S Let’s do the same problem but with the tax spending multiplier: TM = MPC/(1 – MPC) S Example. Suppose government decides to increase income taxes by a lump-sum $1000. MPC = 0.8. S TM = MPC/(1 – MPC) = 0.8/(1 – 0.8) = 0.8/0.2 = 4 S When Americans lose that $1000, they will cut back their spending by $800 (80%) and savings by $200 (20%). S $1000 lost will now be multiplied by 4, so that a $1000 tax increase will multiply into $4000 additional real GDP lost. S Wait, that totally works out perfectly. It’s even the same answer as before! S That’s true, Ryan and Kyle. S So wait, Mr. Bordelon, does that mean we have two equations we could use to arrive at the same result for lowering taxes? S Actually, Ryan and Kyle, it does. And not just for lowering taxes, but increasing as well. And even better, we can do the same for government transfers. Multiplier Effects of Change in Government Transfers and Taxes S Example. Suppose government decides to lower income taxes by a lump-sum $1000. MPC = 0.9. S When Americans get $1000 back into their pockets, they will save $100 (10%) and spend $900 (90%). S TM = MPC/(1 – MPC) = 0.9/0.1 = 9 S $1000 tax cut will multiply into $9000 additional real GDP. Multiplier Effects of Change in Government Transfers and Taxes S Example. Suppose the government decides to increase transfer payments by a lump-sum of $500. MPC = 0.8. S When Americans receive $500 more disposable income, they will save $100 (20%) and spend $400 (80%). S M = 1/(1 – 0.8) = 1/0.2 = 5 S $400 of new spending will multiply by a factor of 5, meaning a $500 increase of transfers will multiply into $2000 of additional real GDP. S Now with the tax multiplier… Multiplier Effects of Change in Government Transfers and Taxes S Example. Suppose the government decides to increase transfer payments by a lump-sum of $500. MPC = 0.8. S When Americans receive $500 more disposable income, they will save $100 (20%) and spend $400 (80%). S TM = MPC/(1 – MPC) = 0.8/(1 – 0.8) = 0.8/0.2 = 4 S $500 increase in transfers will multiply by a factor of 4, meaning an additional $2000 of real GDP. Multiplier Effects of Change in Government Transfers and Taxes S Example. Suppose the government decides to decrease transfer payments by a lump-sum of $500. MPC = 0.8. S When Americans lose $500 in disposable income, they will decrease their savings by $100 (20%) and spending by $400 (80%). S M = 1/(1 - MPC) = 1/(1 – 0.8) = 1/0.2 = 5 S $400 decrease in transfers will multiply by a factor of 5, meaning an additional $2000 of real GDP lost. Multiplier Effects of Change in Government Transfers and Taxes S Example. Suppose the government decides to decrease transfer payments by a lump-sum of $500. MPC = 0.8. S When Americans lose $500 in disposable income. S TM = MPC/(1 – MPC) = 0.8/(1 – 0.8) = 0.8/0.2 = 4 S $500 decrease in transfers will multiply by a factor of 4, meaning an additional $2000 of real GDP lost. Taxes and the Multiplier S In reality, the eventual impact of discretionary fiscal policy is lessened by the progressive tax system. S S Discretionary because it’s a choice. Assume the economy is in recession and the government has increased G to boost employment and real GDP. S S S 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. 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. S S The progressive tax system is a form of automatic stabilizer. This is also called “non-discretionary” fiscal policy. Question 1 S Real GDP is currently $600 billion above potential GDP and price inflation is beginning to dominate the headlines. How could the government adjust taxes or transfers to return the economy to full employment? How large would this lump-sum adjustment need to be? MPC =.75. Question 2 S Current real GDP is $6 trillion and potential GDP is $7.5 trillion. The government is prepared to pass a spending package to return the economy to full employment. What kind of spending package should be passed and how big does it need to be? MPC = .90.