Gmultiplier SFLS

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The Multiplier Effect

Sooooooo1.) Full employment- about 5% unemployment2.) Stability (Prices) 3.) Economic growth 4.) Balance of Payments Equilibrium - about 2% inflation- about 3% growth (7% in China)AD = C + I + G + (X M) These are our Macroeconomic goalsThis is our Macroeconomic equationAnd the G in the equation is the government attempting to smooth out the business cycle with its policyExpansionary Fiscal PolicyContractionary Fiscal Policy

AD = C + I + G + (X M) And there are two ways to enact either policy Government spending Taxes And the two ways this is accomplishedDiscretionary Fiscal PolicyAutomatic Stabilizers

Keep trade deficits low, but no percentage number as a guideAD = C + I + G + (X M) Federal BudgetAnd there are the resources used to do thisWhich comes from eitherTaxesBorrowingSoooooooooooo.The next question is how effective are these policies

Big G ManThis Man represents the Government in our economy so we will call himFiscal Policy Effectiveness Example

I work for the Government!Big G ManLets look at our countrys AD!Fiscal Policy Effectiveness Example

Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASBig G ManOh No! the AD is below the long run equilibrium!Fiscal Policy Effectiveness Example

Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASI am sad for my country

Big G ManFiscal Policy Effectiveness Example

Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASLets check the GDP spending numbersBig G ManFiscal Policy Effectiveness Example

Price levelGDPAD

SRAS

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YN

Y1

P1

LRASLets check the GDP spending numbersAD = Y1 = 90 billion current GDPAD =YN = 100 billion GDP GoalBig G ManFiscal Policy Effectiveness Example

Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASAD = Y1 = 90 billion current GDPAD =YN = 100 billion GDP GoalBig G ManOur country has a $10 billion shortfall in ADFiscal Policy Effectiveness Example

Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASAD = Y1 = 90 billion current GDPAD =YN = 100 billion GDP GoalBig G ManOk simply, the government can just spend $10 billion to fill this hole!Fiscal Policy Effectiveness Example

G

Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASOk simply, the government can just spend $10 billion to fill this hole!

$10 billion Spending= AD

$10 billionBig G ManFiscal Policy Effectiveness Example

G

Price levelGDPAD

SRAS

PE

YN

Y1

P1



$10 billionFiscal Policy Effectiveness ExampleBig G Man

G

Price levelGDPAD

SRAS

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YN

Y1

P1



$50 billionY2P2Big G Man If MPC is 0.8 ( ) Fiscal Policy Effectiveness Example

G

Price levelGDPAD

SRAS

PE

YN

LRASOh no! the economy is overheating and now we have too much inflation!


$50 billionAD1

Y2

P2= Inflation

Fiscal Policy Effectiveness Example

G

Price levelGDPAD

SRAS

PE

YN

LRASWhat did I do wrong?


$50 billionAD1

Y2

P2= Inflation

Fiscal Policy Effectiveness Example

Expansionary Fiscal PolicyAD = C + I + G + (X M)

Government spending

Price levelGDP

AD

SRAS

PE

LRAS

YN

Y1

P1

AD1

Spending in an economy has a multiplier effect


Taxes

Price levelGDP

AD

SRAS

PE

LRAS

YN

Y1

P1

AD1

So do taxes, just a slightly different amount

- the number of times a rise in national income exceeds the rise in injections of demand that caused it

The Multiplier effectFiscal Policy Effectsthe additional shifts in AD that result when fiscal policy increases income and thereby increases consumer spending (C)

Reworded definition: Each $1 increase in G can generate more than a $1 increase in AD.

The Multiplier effectFiscal Policy Effects

11 MPC

=


G spending Equation:or

1MPS

=

They are the same equation, some authors use one, some authors use the other


11 MPC

=



1MPS

=

Tax Equation:

or

Tax Equation:

or

I will show the G spending equation first, then the Tax equation next.

1.) The government buys airplanes from a domestic manufacturer. The Multiplier Effect Example:

1.) The government buys airplanes from a domestic manufacturer. The Multiplier Effect Example:2.) This is distributed to workers (wages) and owners ( profits or stock dividends).


3.) These people are also consumers and will spend a portion of the extra income.



4.) This extra consumption causes further increases in AD.

Price levelGDPAD

- the fraction of extra income that households consumes rather than save

The Multiplier effectFiscal Policy EffectsMarginal Propensity to Consume(MPC)Example:1.) if MPC = 0.82.) if income rises by $1003.) then C consumption rises $80The size of the multiplier depends on MPC.

- the fraction of extra income that households consumes rather than save

The Multiplier effectFiscal Policy EffectsMarginal Propensity to Consume(MPC)Example:1.) if MPC = 0.82.) if income rises by $1003.) then C consumption rises $80The size of the multiplier depends on MPC.

You have only two choice with you money: Spend it or save it. This means every time you get more income you spend some and you save some. The money you spend is someones new income and they do the same thing. This is about to multiplied effects of this process.

Fiscal Policy EffectsMarginal Propensity to Consume(MPC)The size of the multiplier depends on MPC.

if MPC = 0.5 Multiplier = 2if MPC = 0.75 Multiplier = 4if MPC = 0.9 Multiplier = 10

Example sizes:

- the fraction of extra income that households saves rather than consumes

Fiscal Policy EffectsMarginal Propensity to Consume(MPS)Marginal Propensity to SaveExample:1.) if MPS = 0.22.) if income rises by $1002.) then C consumption rises $80For one round, then do this for multiply rounds until the money has been all used up

Marginal Propensity to Consume Example

Big G Man

I will spend more G money and make a new bridge!Big G Man


So I need to hire some workers to do it.Big G Man


Big G Man

WorkersMarginal Propensity to Consume Example

Big G Man

G


$10 billionWorkersMarginal Propensity to Consume Example

Big G Man

G


$10 billion+ WorkersMarginal Propensity to Consume Example

Workers

Some of this money with will spend (MPC) = 0.8We have earned some wages!Some of this money we will save (MPS) = 0.2Marginal Propensity to Consume Example

Workers

Lets buy some new dresses!


Workers

Dress maker

($10 billion)$8 billion$2 billionMarginal Propensity to Consume Example

Workers

Dress maker

G

$10 billion Spending+workers

$8 billion SpendingMarginal Propensity to Consume Example

Workers

Dress maker

G


$8 billion Spending+ Marginal Propensity to Consume Example

Workers

Dress maker

G


$8 billion Spending+ Marginal Propensity to Consume ExampleKeep going and going until the math is finished

Big G Man

$10 billion SpendingMarginal Propensity to Consume Example

Big G Man

$10 billion Spending

Workers+

+$8 billion SpendingMarginal Propensity to Consume Example

Big G Man


Workers++

Dress maker

+$8 billion Spending$6.4 billion Spending+Marginal Propensity to Consume Example

Big G Man


+ Workers++

Dress maker

+$8 billion Spending$6.4 billion Spending++Marginal Propensity to Consume Example

Big G Man

+ Workers++

Dress makerG

$10 billion Spending+ MPC = 0.8of each round of incomes spending

11 MPC

=


Big G Man

+ Workers++

Dress makerMPC = 0.8of each round of incomes spending

11 MPC

=

Multiplier = 5Marginal Propensity to Consume Example

Big G Man

+ Workers++

Dress makerG


$50 billionxMultiplier of 5Marginal Propensity to Consume Example

The Multiplier EffectA $10billion increase in G initially shifts AD to the right by $10billion.

YP

AD1P1AD2

Y1

Y2

$10 billion0

5050

The Multiplier EffectA $10billion increase in G initially shifts AD to the right by $10billion.

The increase in Y causes C to rise, which shifts AD further to the right.

YP

AD1P1AD2

AD3

Y1

Y3

Y2

$10 billion0

5151

The Multiplier Example Formula:AD = C + I + G + (X M) Government spending

Y = C + I + G + NXidentity Y = C + G I and NX do not change Y = MPC Y + Gbecause C = MPC Y solved for Y11 MPC

Y =G

The multiplier

Marginal Propensity to Consume (MPC)

Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASOk lets try again!Big G Man


Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASLets check the GDP spending numbersBig G Man


Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASLets check the GDP spending numbersAD = Y1 = 90 billion current GDPAD =YN = 100 billion GDP GoalBig G Man


Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASAD = Y1 = 90 billion current GDPAD =YN = 100 billion GDP GoalBig G ManOur country has a $10 billion shortfall in AD


Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASAD = Y1 = 90 billion current GDPAD =YN = 100 billion GDP GoalBig G ManIf I know the MPC in my country is 0.8


Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASThen I use that in this equation

11 MPC

=

= 1/1-0.8= 1/0.2Big G Man


Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRAS

11 MPC

=

= 1/1-0.8= 1/0.2= 5Big G ManNow I know the multiplier!


Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASI only have to spend $2 billion and that will equal $10 billion in total spending!AD = Y1 = 90 billion current GDPAD =YN = 100 billion GDP GoalBig G Man


Big G man

Price levelGDPAD

SRAS

PE

YN

LRASHurry! Our Economy is saved!


Government spending

Price levelGDP

AD

SRAS

PE

LRAS

YN

Y1

P1

AD1

So that is basically the spending side


Taxes

Price levelGDP

AD

SRAS

PE

LRAS

YN

Y1

P1

AD1

Now for the Tax side


11 MPC

=



1MPS

=

Tax Equation:

or

Tax Equation:

or

MPC1 MPC

=

MPCMPS

=

- MPC1 MPC

=

- MPCMPS

=

This one will be the example

The Multiplier Example Formula:AD = C + I + G + (X M) Taxes

Reduced taxes are not an injection of new moneyIt frees up current income into more disposable incomeSome is saved, some is spend, just like the Government Spending Multiplier but without the first injection of new money that is 100% spend.

1.) The government reduces income taxes for peopleThe Tax Multiplier Effect Example:

2.) This is distributed to workers (wages) and owners ( profits or stock dividends).

1.) The government reduces income taxes for peopleThe Tax Multiplier Effect Example:

1.) The government reduces income taxes for peopleThe Tax Multiplier Effect Example:2.) People now have more disposable income (wages) and owners ( profits or stock dividends).





Price levelGDPAD




Price levelGDPAD

However it is one less round then government spending it is a smaller multiplier

Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASBig G ManTax Multiplier Example

Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASAD = Y1 = 90 billion current GDPAD =YN = 100 billion GDP GoalBig G ManOur country has a $10 billion shortfall in ADTax Multiplier Example

What if instead of building a bridge and spending extra money like before, I just gave people tax cuts?Big G Man

Tax Multiplier Example

Big G Man

Workers

Boss of WorkersI will reduce all your taxes so you have more disposable incomeTax Multiplier Example

Big G Man

Workers

Boss of WorkersHurry! I might even hire new workers!Tax Multiplier Example

Big G Man

Workers

Boss of WorkersHurry! I might even hire new workers!


Big G Man

Workers

Boss of WorkersHurry! Now we can buy more dresses!


Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASAD = Y1 = 90 billion current GDPAD =YN = 100 billion GDP GoalBig G ManIf I know the MPC in my country is 0.8 Tax Multiplier Example

Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASThen I use that in this equation

MPC1 MPC

=

= 0.8/1-0.8= 0.8/0.2Big G ManTax Multiplier Example

Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRAS

MPC1 MPC

=

= 0.8/1-0.8= 0.8/0.2= 4Big G ManNow I know the tax multiplier!Tax Multiplier Example

Price levelGDPAD

SRAS

PE

YN

Y1

P1

LRASI have to cut taxes by 2.5 billion to get $10 billion in total spending!AD = Y1 = 90 billion current GDPAD =YN = 100 billion GDP GoalBig G ManTax Multiplier Example

Big G man

Price levelGDPAD

SRAS

PE

YN

LRASHurry! Our Economy is saved!Tax Multiplier Example


11 MPC

=



1MPS

=

Tax Equation:

or

Tax Equation:

or

MPC1 MPC

=

MPCMPS

=

- MPC1 MPC

=

- MPCMPS

=

The Multiplier Effect So the Government can spend money and increase AD by a multiplierOr the Government can decrease taxes an increase AD by a multiplier So the Government spending has a bigger multiplier

The Multiplier Effect So the Government can spend money and increase AD by a multiplierOr the Government can decrease taxes an increase AD by a multiplier So the Government spending has a bigger multiplier However

The Multiplier Effect So the Government can spend money and increase AD by a multiplierOr the Government can decrease taxes an increase AD by a multiplier So the Government spending has a bigger multiplier HoweverDont forget the money isnt free, it comes from the federal budget that has to be balanced, and if its in deficit this adds another problem.

AD = C + I + G + (X M)

Budget Deficit Problem:Crowding out:Government spending and borrowing that may fail to increase AD and hurts private investment.When the government has to borrow, it needs to borrow from the private sector. This could be private individuals, pension funds or investment trusts. It is argued that if the private sector buy government securities this will crowd out private sector investment.

The Multiplier Effect0So a quick example of this

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The economy is in recession. Shifting the AD curve rightward by $200billion would end the recession. A.If MPC = .8 and there is no crowding out, how much should the government increase G to end the recession?B.If there is crowding out, will the government need to increase G more or less than this amount?

The Multiplier Effect Example:

89This exercise gets students to apply the preceding material on the effects of fiscal policy on aggregate demand.

Finding the answers requires students use the formula for the multiplier but does not require that students understand the algebraic derivation of this formula.

The economy is in recession. Shifting the AD curve rightward by $200billion would end the recession. A.If MPC = .8 and there is no crowding out, how much should the government increase G to end the recession?

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The economy is in recession. Shifting the AD curve rightward by $200billion would end the recession. A.If MPC = .8 and there is no crowding out, how much should the government increase G to end the recession?Multiplier = 1/(1 .8) = 5Answer: Increase G by $40billion to shift AD by 5 x $40billion = $200billion

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The economy is in recession. Shifting the AD curve rightward by $200billion would end the recession. B.If there is crowding out, will the government need to increase G more or less than this amount?

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The economy is in recession. Shifting the AD curve rightward by $200billion would end the recession. B.If there is crowding out, will the government need to increase G more or less than this amount?- Crowding out reduces the impact of G on AD.Answer: To offset this, the government should increase G by a larger amount, how much depends on the math involved.

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0Hope you understand

That is all!

Thank you!

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Gmultiplier SFLS

Education

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