1. FISCAL POLICY
AND THE MULTIPLIER
MODULE 21

2. USING THE MULTIPLIER TO ESTIMATE THE
INFLUENCE OF GOVERNMENT POLICY
 Expansionary fiscal policy shifts the AD curve to the
right, and contractionary fiscal policy shifts the AD
curve to the left.
 However, just knowing the direction of the shift is not
enough, policy makers need estimates of how much
the AD curve is shifted by a given policy.
 In order to get these estimates, the policy makers
use the concept of the multiplier.

3. MULTIPLIER EFFECTS OF AN INCREASE IN
GOVERNMENT SPENDING
 The government’s purchases of goods and services
starts a chain reaction throughout the economy.
Households
Government Firms Earn receive income
Spending Revenues (wages, profit,
interest, and rent
 This increase in disposable income will lead to a rise
in consumer spending, which induces firms to
increase output, leading to a further rise in
disposable income, which will lead to another round
of consumer spending increases, and so on…

4. MULTIPLIER EFFECTS OF AN INCREASE IN
GOVERNMENT SPENDING
 This effect is due to the multiplier: the ratio of the
change in real GDP caused by an autonomous
change in aggregate spending to the size of that
autonomous spending.
 Therefore, any change in government spending will
lead to an even greater change in real GDP.
 The initial change in spending, multiplied by the
multiplier, will give us the final change in real GDP.
 A reduction in government spending will have the
same effect, but with a negative sign, reducing real
GDP more than the initial change in spending.

5. MULTIPLIER EFFECTS OF CHANGES IN
GOVERNMENT TRANSFERS AND TAXES
 Expansionary or contractionary fiscal policy is not
only undertaken by changing government spending.
 Governments can also change transfer payments or
taxes.
 However, a change in government transfers or taxes
shifts the AD curve by less than an equal-size change
in government purchases, which results in a smaller
effect on real GDP.
 In the case of transfer payments, households will
only spend a part of the additional income received
(the MPC) and save part (the MPS).

6. HYPOTHETICAL EFFECTS OF A FISCAL
POLICY WITH A MULTIPLIER OF 2
$50 BILLION RISE IN
$50 BILLION RISE IN
GOVERNMENT
EFFECT ON REAL GDP GOVERNMENT
PURCHASES OF
TRANSFER PAYMENTS
GOODS AND SERVICES
FIRST ROUND $50 BILLION $25 BILLION
SECOND ROUND $25 BILLION $12.5 BILLION
THIRD ROUND $12.5 BILLLION $6.25 BILLION
…
…
…
EVENTUAL EFFECT $100 BILLION $50 BILLION

7. MULTIPLIER EFFECTS OF CHANGES IN
GOVERNMENT TRANSFERS
 Overall, when expansionary fiscal polity 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 be either
more or less than 1).
 If a smaller share of the initial transfer has been
spent, the multiplier on that transfer would be less
than 1; if a larger share of that initial transfer is
spent, the multiplier would be more than 1.

8. MULTIPLIER EFFECTS OF CHANGES IN
GOVERNMENT TAXES
 A tax cut has an effect similar to the effect of a
transfer: it increases disposable income, leading to
a series of increases in consumer spending.
 However, the overall effect is smaller than that of an
equal-size increase in government spending.
 This autonomous increase in aggregate spending is
smaller because households save part of the amount
of a tax cut (the MPS).

9. MULTIPLIER EFFECTS OF CHANGES IN
GOVERNMENT TAXES
 Taxes introduce a further complication: they
typically change the size of the multiplier.
 In the real world, government rarely impose a lump-
sum tax (in which the amount of a tax a household
owes is independent of its income).
 Instead, tax revenue is raised via taxes that depend
positively on the level of real GDP, which reduce the
size of the multiplier.

10. MULTIPLIER EFFECTS OF CHANGES IN
GOVERNMENT TAXES
 Economists argue that it also matters who gets the
tax cuts or increases in government transfers.
 A dollar spent on unemployment benefits increases
AD more than a dollar’s worth of dividend tax cuts,
as people with lower incomes tend to spend a higher
share of any increase in disposable income and
wealthier people tend to save more of any increase
in disposable income.

11. 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, since most government taxes
depend positively on real GDP.
 Therefore, disposable income increases by
considerable less than $1 once taxes are included in
the model.
 The increase in government tax revenue when GDP
rises is not a deliberate action of the government; it
is a consequence of the way tax laws are written.
 Sources of government revenue increase
automatically when real GDP increases.

12. TAXES AS AUTOMATIC STABILIZERS
 Income tax receipts increase when real GDP rises
because the amount each individual owes in taxes
depends positively on income, and households’
income rises when real GDP rises.
 Sales tax receipts increase when real GDP rises
because consumption increases and people buy
more goods and services.
 Corporate profit tax receipts increase when real GDP
rises because profits increase when the economy
expands.

13. TAXES AS AUTOMATIC STABILIZERS
 The effect of these automatic increases in revenue is
to reduce the size of the multiplier.
 Since the government takes away some of the
increase in real GDP (in the form of taxes) at each
successive round of spending, the increase in
consumer spending is smaller than it would be if
taxes weren’t part of the process.
 The result of this is to reduce the multiplier.

14. TAXES AS AUTOMATIC STABILIZERS
 The same mechanism that causes tax revenue to
increase when real GDP rises causes it to fall when
the economy contracts, so the effects of the negative
demand shocks are smaller than they would be if
there were no taxes.
 The decrease in tax revenue reduces the negative
effect of the initial fall in AD.
 This automatic decrease in government tax revenue
caused by a fall in real GDP (caused by a decrease in
the amount of taxes households pay) acts like an
automatic expansionary fiscal policy: a decrease in
taxes.

15. TAXES AS AUTOMATIC STABILIZERS
 The automatic increase in government tax revenue
caused by a rise in real GDP (caused by an increase
in the amount of taxes households pay) acts like an
automatic contractionary fiscal policy: an increase in
taxes.
 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, are
called automatic stabilizers.

16. OTHER AUTOMATIC STABILIZERS
 These rules that govern tax collection are not the
only automatic stabilizers, but they are the most
important ones.
 Transfer payments tend to rise when the economy is
contracting and fall when the economy is expanding.
 Like changes in tax revenue, automatic changes in
transfers tend to reduce the size of the multiplier
because the total change in disposable income that
results from a given rise or fall in real GDP is
smaller.

17. DISCRETIONARY FISCAL POLICY
 Discretionary fiscal policy is fiscal polity that is the
direct result of deliberate actions by policy makers,
rather than automatic adjustments
 Generally, due to time lag problems, economist tend
to support the use of discretionary fiscal policy only
in special circumstances.
 The size of automatic stability depends on
responsiveness of changes in taxes to changes in
GDP: The more progressive the tax system, the
greater the economy’s built in stability
 Automatic stability reduces instability, but does not
correct economic instability.

18. EXERCISE: COPY THIS TABLE
GDP (Billions) Consumption (Billions)
$100 $120
200 200
300 280
400 360
500 440
600 520
700 600

19. EXERCISE (CONT.)
a) Graph this consumption schedule, and determine
the size of the MPC.
b) Assume a lump sum (regressive) tax of $10 billion
is imposed at all levels of GDP. Calculate the tax
rate at each level of GDP. Graph the resulting
consumption schedule, and compare the MPC and
the multiplier with those of the pre-tax
consumption schedule.
c) Now suppose a proportional tax with a 10 percent
tax rate is imposed instead of the regressive tax.
Calculate and graph the new consumption schedule
and note the MPC and the multiplier

20. EXERCISE (CONT.)
d) Finally, impose a progressive tax such that the tax
rate is 0% when GDP is $100, 5% at $200, 10% at
$300, 15% at $400, and so forth. Determine and
graph the new consumption schedule, noting the
effect of this tax system on the MPC and the
multiplier.
e) Explain why proportional and progressive taxes
contribute to greater economic stability, while a
regressive tax does not. Demonstrate using a
graph.

21. EXERCISE PART a)


22. EXERCISE PART b)
GDP, Tax, DI, Consumption Tax rate,
billions billions billions after tax percent billions
$100 $10 $90 $112 10%
200 10 190 192 5.0
300 10 290 272 3.3
400 10 390 352 2.5
500 10 490 432 2.0
600 10 590 512 1.7
700 10 690 592 1.4

23. EXERCISE PART c)
GDP, Tax, DI, Consumption after
billions percent billions tax
$100 10% $90 $112
200 10 180 184
300 10 270 256
400 10 360 328
500 10 450 400
600 10 540 472
700 10 630 544

24. EXERCISE PART d)
GDP, Tax, DI, Consumptio Tax rate, MPC
billions billions billions n after tax percent
$100 $0 $100 $120 0% undefined
200 10 190 192 5 0.72
300 30 270 256 10 0.64
400 60 340 312 15 0.56
500 100 400 360 20 0.48
600 150 450 400 25 0.40
700 210 490 432 30 0.32
• The MPC decreases, so the multiplier changes.
• Proportional and (especially) progressive tax systems reduce
the size of MPC and therefore, the size of the multiplier.
• A lump sum tax does not change the MPC or the multiplier.