Module 21 – Fiscal Policy and the Multiplier

1. Using the Multiplier to Estimate the Influence of Government Policy
   1. Multiplier Effects of an Increase in Government Purchases of Goods and Services

i.      Concept of the multiplier: the ratio of the change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change.

ii.      Multiplier = 1/(1-MPC)

1. Multiplier Effects of Change in Government Transfers and Taxes

i.      In general, a change in government transfers or taxes shifts the aggregate demand curve by less than an equal-sized change in government purchases, resulting in a smaller effect on real GDP.

ii.       Lump-sum taxes are taxes that don’t depend on the taxpayer’s income.

1. How Taxes Affect the Multiplier

i.      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. As a result, disposable income increases by considerably less that $1 once we include taxes in the model.

ii.      The 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 up.

iii.      The effect of these automatic increases in tax revenue is to reduce the size of the multiplier.

1. The multiplier is the result of a chain reaction in which higher real GDP leads to higher disposable income, which leads to higher consumer spending, which leads to further increase in real GDP.

iv.      Most recessions are the result of negative demand shocks. The same mechanism that causes tax revenue to increase when the economy expands causes it to decrease when the economy contracts.

v.      Automatic stabilizers are government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically Contractionary when the economy expands.

vi.      Discretionary fiscal policy is fiscal policy that is the result of deliberate actions by policy makers rather than rules.