L ESSON 21 Fiscal Policy: The Multiplier Effect...Fiscal Policy: The Multiplier Effect LESSON...

LESSON 21

Fiscal Policy: The Multiplier Effect

HIGH SCHOOL ECONOMICS 3rd EDITION © COUNCIL FOR ECONOMIC EDUCATION, NEW YORK, NY314

LESSON 21

Fiscal Policy: The Multiplier Effect

LESSON DESCRIPTIONStudents are assigned to six groups of

similar size. Each group is given a brief out-line of a fiscal policy play in which they will have a role. Each group has 5–10 minutes to prepare its play, including writing its lines. The groups perform the plays for the class, demonstrating the effectiveness or shortcom-ings of a specific fiscal policy. The teacher then leads students in an activity that uses visuals to describe types of fiscal policy and the power of multipliers.

INTRODUCTION The government is often blamed when

the economy experiences unemployment, decreasing gross domestic product, or inflation. Many economists believe that the federal government can, and should, help alleviate these problems by using traditional, discre-tionary fiscal policy. According to traditional (or demand side) fiscal policy, the govern-ment should increase spending on goods and services or reduce taxes to increase aggregate demand in times of recession and above-normal unemployment. This is called expansionary fiscal policy.

Expansionary fiscal policy actions have direct and indirect effects on the economy. Direct effects are what happen when govern-ment spending creates new income for households. For example: The government hires construction workers for a bridge project.

Indirect effects are “down-the-line” or ripple effects that occur when an indi-vidual receives new income and spends all or part of it on goods or services that then have an effect on the purveyors of those goods and services and beyond. The

construction workers, for example, may decide to eat out more often, creating new income for restaurant workers. Economists call this the multiplier effect. Provided this additional spending occurs, expansionary fiscal policy is more effective in boosting jobs and output, alleviating the impact of a recession.

But expansionary fiscal policy can also have a crowding-out effect. This happens when increased government spending or lost tax revenue obligates the govern-ment to borrow, increasing government debt. Increased government borrowing can lead to increased interest rates and limited funds available for private borrowing, which causes spending on capital investment to be curtailed.

Traditional fiscal policy advocates a role for government in times of inflation, too—contractionary fiscal policy. In the case of inflation, the government can decrease spending on goods and services or increase taxes to decrease aggregate demand. Con-tractionary policy has a similar multiplier effect, because cuts in spending and tax increases reduce household income, causing households to spend less.

COMPELLING QUESTIONHow does government fiscal policy affect spending throughout the economy?

CONCEPTSFiscal policy

Expansionary fiscal policy

Tax policy

Contractionary fiscal policy

BK-CEE-ECONOMICS-131302.indb 314 13-06-2014 03:25:20

HIGH SCHOOL ECONOMICS 3rd EDITION © COUNCIL FOR ECONOMIC EDUCATION, NEW YORK, NY 315

FISCAL POLICY: THE MULTIPLIER EFFECT LESSON 21

Multiplier effect

Crowding-out effect

OBJECTIVESStudents will be able to:

Define expansionary and contractionary fiscal policy.Explain how multipliers increase the impact of fiscal policy.Explain how crowding out can diminish the impact of fiscal policy.Analyze conditions that make fiscal policy more effective in influencing the economy.

CONTENT STANDARDSVoluntary National Content Standards in Economics

Standard 20: Federal government budgetary policy and the Federal Reserve System’s monetary policy influence the overall levels of employment, output, and prices.

Common Core State Standards

CCSS.ELA-Literacy.RH.11-12.7: Integrate and evaluate multiple sources of informa-tion presented in diverse formats and media (e.g., visually, quantitatively, as well as in words) in order to address a question or solve a problem

TIME REQUIRED50 minutes

MATERIALSSlides 21.1–21.10Activity 21.1, nine copiesActivity 21.2, five copiesActivity 21.3, five copiesActivity 21.4, five copies

Activity 21.5, five copiesActivity 21.6, six copiesActivity 21.7, one copy per studentBlank notecards to serve as “scripts,” one per student (optional)A noisemaker, such as a bell, whistle, cymbals, or two sticks to bang together

PROCEDURES (Note: This lesson can be modified to accom-modate class size. There are enough roles for 35 students; for larger classes, the Nar-rator role can be shared. For a class of 25, the teacher may choose to read the Narrator and President roles. For smaller classes, the teacher may have the same students per-form multiple acts, eliminate some acts or postpone the contractionary fiscal policy act [Activity 21.6] for another day.)

1. Tell students that today they will participate in one of a series of short acts in a play about fiscal policy. Explain that fiscal policy is a government’s course of action to influence economic performance through taxation or govern-ment spending. These plays are different from typical plays, because the actors will write their own lines.

2. Divide the class into groups, assign-ing group numbers as you go: Group 1, nine students; Group 6, six students; Groups 2, 3, 4, and 5 will each have five students. Give each group the activity sheet that corresponds to its group num-ber (Group 1 gets Activity 21.1, and so forth). Read through the instructions for the activities—they are the same for all groups. Show Slide 21.1, which provides an example. Tell students they will have 5–10 minutes to choose parts and pre-pare a few lines for each person. Instruct them to write down their lines on note-cards. To perform each play, students will line up next to each other in order; each will deliver his or her lines to the next person. Emphasize that each play



LESSON 21 FISCAL POLICY: THE MULTIPLIER EFFECT

should take about five minutes to per-form, so each character will have only a few lines.

3. Give students about 10 minutes to work in their groups, as you answer questions and make sure students are on track. You may want to assign a leader and a scribe to each group, to ensure that work is completed.

4. Distribute Activity 21.7 to each student. Ask Group 1 to come to the front of the room to perform Act 1. Ask for one volun-teer who is not in the play to ring a bell (or use another noisemaker) each time someone in the play says they are spend-ing money. Ask students to note the prob-lem, the policy solution, and the impact of each policy in Activity 21.7. When the first group has finished, give them a round of applause and tell students that you will discuss the economic events after all acts have been performed.

5. Repeat with Groups 2, 3, 4, 5, and 6, with a different student volunteer using a noisemaker. Students should focus on what is different about each subsequent act. After each act, give students a few minutes to finish their notes.

6. Ask: What happened in the first act of this play?

The economy is in a recession. The presi-dent announced increased spending of $200 billion; some of it went to the teacher. The teacher bought a computer, which helped the computer store hire someone, and so on. There should have been a lot of noise.

Show Slide 21.2. Explain that the gov-ernment spending put money in the teacher’s pocket. The teacher spent the money, which led to a chain reaction of spending in the economy: Teacher to computer store to computer technician to restaurant owner to cook to jewelry store

owner, jewelry store employee, airline, and beyond. The government spending had a direct effect—the teacher’s salary—and indirect effects—spending on the com-puter technician, cook, and wait staff.

a. Ask: Do you think the indirect effects will continue?

Yes, employees at the airline and hotels affected by the jewelry store employee will also spend money.

b. Ask: Do you think the government spending set in motion other chain reactions like this one?

Yes, each person who received money is likely to spend all or part of it.

The change in GDP caused by the $200 billion fiscal policy can be significantly larger than $200 billion. Show Slide 21.3 and define the multiplier effect.

7. Ask: What was different in the second act?

This time, the economy is in better shape, but not in a time of robust expansion. Also, interest rates are rising, and banks don’t have as much money to lend. This was not an issue in the first act because the recession was so severe.

a. Is the chain reaction the same in this act?

It is not performed, but the teacher’s spending would probably still help the computer store and so forth.

b. What happens to the construction company?

The construction company can’t bor-row money to invest, so it doesn’t buy equipment.

Tell students that economists call this a crowding-out effect.




8. Show Slide 21.4, with its definition of the crowding-out effect. If crowding out occurs, what happens to the multiplier effect and the change in GDP?

The fiscal policy won’t have as large an effect. GDP will change by a smaller amount or not at all.

Explain that crowding out is more likely to happen with the economy closer to full employment and with higher interest rates. In a deep recession, there is less demand for business investment anyway, and the central bank is likely to keep interest rates low and credit available.

9. Ask: What happened in Act 3?

The economy is in a deep recession. The president announced permanent tax cuts of $200 billion, targeting lower- and middle-income households.

How was the impact of the tax cut dif-ferent than the increase in government spending?

The store clerk and barista spend some—but not all—of their additional income.

10. Show Slide 21.5. Explain that the store clerk received additional income but decided to save some. Unlike increased government spending, a tax cut does not have a direct effect. A tax cut increases GDP only indirectly—if the individuals who receive more income decide to spend it. Lower- and middle-income households are likely to spend a significant por-tion of a permanent tax cut, however, so this $200 billion tax cut is still likely to have a large impact on GDP, especially during a severe recession. (Note: There are fewer dollar signs around the circle because the first recipient did not spend all of the money.)

11. Ask students to recall what happened in Act 4.

The economy is in a deep recession. This time, the president announced a one-time $200 billion tax rebate.

a. Did the consumers spend their windfall?

For the most part, no. Most of the money was saved or used to pay down debts.

b. Will this have as significant an impact as the policies in Act 1 and Act 3?

No, not if people don’t spend the money.

12. Show Slide 21.6. Note what happens if the recipient of a rebate check does not spend it. There is no direct or indirect effect on GDP because no new goods or services were purchased. Note that although each individual received money, most of their actions did not set off a chain reaction. Because the manufac-turing worker didn’t buy anything new (like the computer the teacher bought in Act 1), there was no new income to the computer store or the computer techni-cian. Likewise, no money flowed to the cook or jewelry store or airline. Economic research has demonstrated that house-holds are much less likely to spend a one-time tax rebate than money received from a permanent tax cut. In Act 4, the accountant did spend part of the rebate, so that spending would cause a chain reaction, but even the accountant only spent a third of the rebate. The total impact is much smaller.

13. Ask students to recall what happened in Act 5.

The economy is in a deep recession. The president has announced a $200 billion tax cut that will impact only the wealthi-est Americans.




a. What did the wealthy households do with their additional income?

One bought stocks and bonds; one made a donation that went outside the country; one used the money instead of borrowing to expand a business.

b. What direct effects did you note?

None

c. What indirect effects?

The business expansion would have an indirect effect, but this would have happened anyway.

14. Show Slide 21.7. This time, money went to some households, but in most cases, it did not result in additional purchases of goods or services. What would be the impact on GDP?

Little impact

15. Ask: What happened in Act 6?

This time, the economy was suffering from high inflation. The president announced a $200 billion tax increase.

a. Was there a direct effect?

No, but there would be if government cut back on purchases.

b. Was there a chain reaction or multi-plier effect?

Yes, but it was in a negative direction.

c. Show Slide 21.8. How would we show the impact of this contractionary fiscal policy? Show Slide 21.9.

The housewife has less to spend, which means the furniture manu-facturer and store lose revenue and

must cut back on employees. The same happens to the restaurant, as the loss of income ripples through the economy.

d. What impact would this policy have on GDP?

GDP would decrease.

What impact would it have on the price level?

Prices would come down, as work-ers and raw materials become less expensive.

Economists believe that contraction-ary fiscal policy, though seldom used, is effective at combating inflation, partly because of indirect effects.

16. Show Slide 21.10. Review the definitions of expansionary and contractionary fiscal policy.

a. Which acts demonstrated expansion-ary fiscal policy?

Acts 1–5

b. Which expansionary fiscal policy strategies were performed?

Government spending increases, permanent tax cuts, and temporary tax rebates

c. Which acts demonstrated contrac-tionary fiscal policy?

Act 6

d. Which contractionary strategy was performed?

A tax increase

17. Conclude the lesson by noting that the plays illustrated that the multiplier




effect was stronger when people spent a larger portion of their income. Tell stu-dents that the proportion of additional income that people spend is called the marginal propensity to consume (MPC). Ask: When do people spend more of their income?

When a tax cut is permanent as opposed to temporary or when someone’s income is relatively low.

18. Optional: You may want to award an “Adam” for the best acting performance in an economics class.

CLOSURE19. Ask the following questions for review:

a. What is fiscal policy?

The use of tax cuts or spending to influence economic performance

b. What kind of policy is appropriate during a recession?

Expansionary fiscal policy

c. What kind of policy is appropriate during a period of inflation?

Contractionary fiscal policy

d. What do economists call the chain reaction of spending that can happen as a result of expansionary policy?

Multiplier effect

e. In what situation is the multiplier most effective in increasing GDP?

When there is a severe recession with low interest rates

f. Which expansionary policy has a larger direct effect, increased govern-ment spending or tax cuts?

Increased government spending

g. Who is more likely to spend the additional income that comes from a tax cut—low-income or high-income households?

Low income

h. Which is likely to have more impact on GDP, a permanent tax cut or a one-time rebate?

A permanent tax cut

20. Conclude by noting that macroecono-mists spend much of their time estimat-ing the size of multiplier effects and deciding which fiscal policies work best. This lesson has illustrated some of the basic principles behind multiplier effects, but their effectiveness is continually debated.

ASSESSMENTMultiple Choice

1. Which of the following best defines the multiplier effect?

a. As a result of government tax cuts, many consumers may decide to save a portion of their additional after-tax income.

b. An increase in spending by government results in changes in GDP greater than the original spending increase.

c. Government spending causes a direct effect on GDP but no indirect effects.

d. Government tax cuts are likely to result in a change in overall output.




2. Which of the following expansionary fiscal policies is likely to have the largest impact on GDP?

a. A permanent tax cut aimed at upper-income households

b. A permanent tax cut aimed at middle-income households

c. A temporary tax cut aimed at upper-income households

d. A temporary tax cut aimed at middle-income households

3. The crowding-out effect happens when

a. government borrowing drives up interest rates and decreases investment spending.

b. government borrowing drives down interest rates and decreases invest-ment spending.

c. government spending causes a multiplier effect that doesn’t affect business firms.

d. contractionary fiscal policy causes a chain reaction of decreased income and spending.

Constructed Response

The economy of Freelandia is in a severe recession. The GDP has contracted for five straight quarters, unemployment is at 12 percent, inflation is around one percent,

and business investment is low—despite low interest rates.

1. What are two expansionary fiscal policies the government of Freelandia could use?

Increase government spending, cut taxes

2. Define the multiplier effect.

An increase in government spending or a tax cut that results in a much larger change in GDP than the increase in spending or size of tax cut

3. Which policy is likely to have the largest impact on Freelandia’s GDP, based on your understanding of the multiplier effect?

Increase government spending

4. Is Freelandia likely to experience a multiplier effect if its government implements the policy suggested in question 3? Explain.

Yes, because this is a severe recession and interest rates are low.

SOURCEEstimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Outlook from April 2012 through June 2012. Rep. N.p.: Congressional Budget Office, August 2012. PDF version.




ACTIVITY 21.1Fiscal Policy: A Play in Six Acts—Act 1

Instructions

In your group, choose parts and write a few lines for your role on notecards or pa-per. To perform the play, line up next to each other in order and deliver your lines to the person next in line.

Setting

Your town, U.S.A.

Time

In the near future, when you are adults in the workforce

Characters and Description of Roles

1. Narrator/Economist: Opens Act 1 of the play. Announces that the economy is in a deep recession. Gross domestic product has decreased steadily in the past year, along with consumer spending and business investment, which has resulted in increased unemployment nationwide. People are calling for the government to do something to help. The Federal Reserve has reduced inter-est rates to a very low level, but it has not helped. (Narrator/Economist also has a role at Act 1’s conclusion.)

2. President of the United States (via radio broadcast): Announces that the government will increase spending by $200 billion. The money will be spent to hire additional firefighters, police officers, and teachers. In addition, money will go toward new road and bridge projects. The president should point out that the recession is not his or her fault and that this spending should help stimulate the economy and create jobs.

3. Unemployed teacher: Is delighted to learn that he or she will have a job, after being laid off during the recession. Decides to purchase a new laptop computer, a purchase the teacher had been delaying when he or she wasn’t sure there would be a steady paycheck.

4. Computer store manager: Describes how computer sales have increased recently. Needs more workers to handle the additional consumer demand.




5. Unemployed computer technician: Gets hired at the computer store and is happy to be working again. Celebrates by taking the family out to dinner.

6. Restaurant owner: Explains that more and more people have been coming to the restaurant lately, so she or he will hire another cook as well as more wait staff.

7. Recent cooking school graduate: Had heard that it would be hard to find a job. Is very excited to be hired right away. Decides to buy a ring and propose to significant other.

8. Jewelry store owner: Notices a dramatic increase in the number of couples shopping for engagement rings and pays bonuses to employees.

9. Jewelry store employee: Excited to get his or her first-ever bonus. Spends it on plane tickets to Tahiti.

10. Narrator/Economist: Summarizes the effects of the increased government spending by pointing out that it has encouraged consumer spending and increased business staffing. As individuals and businesses spent more money, more goods and services were produced. GDP increased; unemployment de-creased.





Instructions


Setting

Your town, U.S.A.

Time



1. Narrator/Economist: Opens Act 2 of the play. Announces that the economy is doing OK. Gross domestic product has increased slightly, and unemployment is at 5.8 percent. The Federal Reserve has kept interest rates at a moderate level in an effort to keep inflation down. Although conditions are not terrible, people are calling for the government to do something to help reduce unemployment further. (Narrator/Economist also has a role at Act 2’s conclusion.)

2. President of the United States (via radio broadcast): Announces that the government will increase spending by $200 billion. The money will be spent on firefighters, police officers, and teachers. In addition, money will go toward new road and bridge projects. The president should point out that the slow economy is not his or her fault; this spending should help stimulate the economy and create jobs.

3. Banker: Explains that the government needs to borrow money for this new spending because it is not raising taxes. The government has issued new bonds, and the bank has purchased a lot of them with its cash reserves. This means his or her bank no longer has as much money to lend to business firms and households. Because the Fed is not holding interest rates low, they have drifted higher, and borrowing has become much more difficult for households and firms.




4. Teacher: Is delighted to learn that she or he will have a job. Decides to buy a new computer, a purchase that had been delayed when employment was in question.

5. Construction company owner: Is excited to hear about new road and bridge projects and decides this would be a good time to invest in new equip-ment. However, when he or she goes to the bank to borrow money to buy new machinery, interest rates are much higher than expected, and he or she chooses not to invest.

6. Narrator/Economist: Summarizes the effects of the increased government spending by pointing out that it has encouraged both consumers and busi-nesses to plan new purchases. However, the government borrowing has pushed up interest rates and made it more difficult to borrow funds. The impact on GDP and unemployment is lessened.





Instructions


Setting

Your town, U.S.A.

Time



1. Narrator/Economist: Opens Act 3 of the play. Announces that the economy is in a deep recession. Gross domestic product has decreased steadily over the past year, along with consumer spending and business investment. This has resulted in increased unemployment nationwide. People are calling for the gov-ernment to help. The Federal Reserve has already reduced interest rates to a very low level, and it has not helped. (Narrator/Economist also has a role at Act 3’s conclusion.)

2. President of the United States (via radio broadcast): Announces that the government will cut personal income taxes by $200 billion. The tax cuts are permanent and will target middle- and lower-income households. The president should point out that the recession is not his or her fault and that this spend-ing should help stimulate the economy and create jobs.

3. Retail store clerk: Is thrilled to receive more money in each paycheck. Decides to save a third of the increased take-home pay, in case her or his hours get cut again, and begins buying more expensive coffee on the way to work each day.

4. Coffee shop manager: Describes how coffee sales have increased moderately, though not as much as expected with the huge federal tax cut. Needs to hire one more barista to handle the additional customer demand.




5. Unemployed recent college graduate: Gets hired at the coffee shop and is happy to be working, even if it’s not a permanent position in speech therapy. Plans to save 15 percent of his or her income to return to school, but will have more to go to the movies now.

6. Narrator/Economist: Summarizes the effects of the tax cut by pointing out that it has encouraged consumer spending, but that consumers have saved part of the additional income rather than spending it, which diminishes the impact compared to direct government spending. As individuals and businesses spent more money, more goods and services were produced. GDP increased; unemployment decreased.





Instructions


Setting

Your town, U.S.A.

Time



1. Narrator/Economist: Opens Act 4 of the play. Announces that the economy is in a deep recession. Gross domestic product has decreased steadily in the past year, along with consumer spending and business investment. This has resulted in increased unemployment nationwide. People are calling for the government to help. (Narrator/Economist also has a role at Act 4’s conclusion.)

2. President of the United States (via radio broadcast): Announces that the government will immediately issue a $200 billion tax rebate, to be divided among all American families. This is a onetime rebate, intended to encourage spending now. The president should point out that the recession is not his or her fault; spending should help stimulate the economy and create jobs.

3. Manufacturing worker: Is excited to get a $1,500 check in the mail—she or he will use it to pay down huge credit card debt. This will help her or his finances, but she or he won’t buy anything new.

4. College professor: Is eager to get her or his $1,500 check in the mail. Is tempted to spend it on a new professional quality bicycle, but the spouse urges saving instead, because spouse’s hours have been cut back. She or he is torn but will not buy the bike.




5. Accountant: Spent $500 of the $1,500 rebate on plane tickets to California as soon as she or he heard about it, but plans to put the rest of the money in savings account to continue making up for lost value of her or his stock account.

6. Narrator/Economist: Summarizes the effects of the rebate by pointing out that consumers saved most of the money, rather than spending it and stimulat-ing the economy. Concern about the economic future and the fact that this is a one time payment make consumers less likely to spend their windfall.





Instructions


Setting

Your town, U.S.A.

Time



1. Narrator/Economist: Opens Act 5 of the play. Announces that the economy is in a deep recession. Gross domestic product has decreased steadily in the past year, along with consumer spending and business investment. This has resulted in increased unemployment nationwide. People are calling for the government to do something to help. (Narrator/Economist also has a role at Act 5’s conclusion.)

2. President of the United States (via radio broadcast): Announces that the government has passed a $200 billion tax cut, directed at people in the highest tax brackets (the wealthiest Americans). This is a permanent tax cut, intended to encourage spending and a trickle-down effect. The president should point out that the recession is not his or her fault and that this spending should help stimulate the economy and create jobs.

3. Corporate CEO: Was happy to be informed by her or his tax preparer that she or he will have significantly more take-home income; plans to use the money to enlarge portfolio of stocks and bonds.

4. Movie star: Is excited to suddenly have millions more to spend. He or she an-nounces intent to increase donations to a “Clean Water for Africa” campaign by an amount equal to his or her tax savings.




5. Fashion designer: Is happy to learn that she or he can pay for an expansion of the leather merchandise facility without borrowing. She or he had planned the expansion and now won’t need to pay interest on a loan.

6. Narrator/Economist: Summarizes the effects of the rebate by pointing out that the wealthiest Americans are less likely to spend additional income on consumer goods because they can already afford upscale homes, vehicles, vaca-tions, jewelry, and clothing.





Instructions


Setting

Your town, U.S.A.

Time



1. Narrator/Economist: Opens Act 6 of the play. Announces that the economy has over the last couple of years experienced high and increasing inflation caused by increased demand for output in the economy (demand-pull inflation). Prices are increasing rapidly. People are calling for the government to help. (Narrator/Economist also has a role at Act 6’s conclusion.)

2. President of the United States (via radio broadcast): Announces that the government has passed a $200 billion tax increase, to be spread across all American taxpayers. This is a permanent tax hike, intended to decrease con-sumer spending. The president should point out that the inflation is not his or her fault; this cut will help curb inflation.

3. Married non-working spouse: Explains that the tax increase is severely impacting family finances; family will have to cut back on expenditures such as furniture, dining out, vacations, new clothes, and all other non-essentials.

4. Furniture manufacturer: Comments that business has fallen, so he or she will lay off workers and cut back on orders for new supplies.

5. Furniture store employee: Explains that he or she has lost job at furniture store, must take child out of daycare, stop eating out, and postpone major pur-chases.




6. Restaurant owner: Comments that business has fallen, but the price of raw ingredients has fallen as well, and workers can be hired for lower salaries. De-cides to cut prices of restaurant meals to get customers to return.

7. Narrator/Economist: Summarizes effects of government tax hike by point-ing out that it reduced overall demand in the economy, caused prices to fall, and slowed the rate of inflation. As spending decreased, incomes declined, and prices fell, too.




ACTIVITY 21.7Record Sheet

Act Describe ProblemDescribe President’s

Policy SolutionDescribe Impact on Spending and GDP

1

2

3

4

5

6


L ESSON 21 Fiscal Policy: The Multiplier Effect...Fiscal Policy: The Multiplier Effect LESSON...

Documents

Transcript of L ESSON 21 Fiscal Policy: The Multiplier Effect...Fiscal Policy: The Multiplier Effect LESSON...