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 component of AD



m



Change in Real GDP

The Government Spending Multiplier

• Used to determine the change in government spending needed to close a recessionary gap:

Increase in Government Spending



Size of the Recessionary Gap 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 in taxes



Size of the Recessionary Gap 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 1 1  .

9  $ 10 100     1  1 .

9     1  $ 11 .

11

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.