IntroductionThe issues discussed in macroeconomics are: 1. full employment In the 5Es lesson we have already discussed the importance of these topics in reducing scarcity and receiving the maximum satisfaction possible from our limited resources.  Here we will look at fiscal policy designed to achieve low unemployment or low inflation. Review: Macroeconomic PoliciesThe following is from the lecture on Macroeconomic Policies (NOTE: when I use the term "policies", I always mean "government policies"). What is the role of the government in a market economy? In a market economy (capitalist economy) the government has a limited role, but some people believe that the government should try to help the economy maintain full employment and low inflation. We have discussed in the 5 Es lesson that unemployment results in greater scarcity since some resources are not being used so less will be produced. Government policies may be able to help the economy achieve full employment and therefore reduce scarcity. Stabilization Policies Definition: government policies design to reduce UE and/or inflation All the policies discussed here can be classified as stabilization policies. Demand-Management Policies Definition: Policies design to shift the AD curve in order to reduce unemployment or to reduce inflation. Fiscal Policy Definition: discretionary fiscal policyDeliberate changes in taxes (tax rates) and government spending by Congress to promote full-employment, price stability, and economic growth. HOW MUCH Should the Government Change G or T?So we already know that if there is unemployment the appropriate fiscal policy would be to increase government spending and/or decrease taxes. Here we will discuss HOW MUCH should government spending be increased or taxes cut?
GDP = C + I + G + Xn 400 Look at the graph to the right and the formula above. You can see that this economy is at equilibrium producing an output of $400, but if there were full employment, a real GDP of $500 could be achieved. Therefore, this economy has an unemployment problem and is not producing as much as it could. What is the appropriate fiscal policy could the government use to move this economy to full employment? By HOW MUCH should government spending be increased to achieve and equilibrium of $500 and full employment?
One would think that if government spending was increased by $100 that GDP would go up by $100, BUT THIS IS NOT THE CASE! What we are going to learn in this chapter is that a small initial increase in spending results in a much larger change in GDP. This is called the MULTIPLIER EFFECT. A small initial change in spending will result in a larger change in GDP as the spending change works it way through the economy. How the multiplier process works: This is because an initial change in spending will cause an initial increase in GDP and it also becomes income to someone else. (If I buy a new car, people who built and sold that car earn income equal to the price of the car.) What will these people do with their additional income? Well, they will spend some and save some. The amount that they spend increases GDP even more AND it also becomes income to someone else. These other people will spend some of this additional income and save some. The amount THEY spend increases GDP again and becomes income to someone else. This process continues so that the TOTAL change in GDP is much larger than the initial change in spending. This multiplier process helps explain why cities want the superbowl, political conventions, or the Olympics to be held in their town. It's not just because these activities bring in people who will spend money and create jobs, but more importantly, this initial change in spending begins the multiplier process so that the total economic effect and the number of jobs created is much larger than the initial spending on these activities alone would cause. Read this article from the Philadelphia Inquirer newspaper (http://home.phillynews.com/gop/news/impa110698.asp). the Republican National Convention was held in Philadelphia in 2000 and in San Diego in 1996. It is clear that civic leaders understand the multiplier effect when they discuss "spinoff benefits".
Above we said that the multiplier works "because an initial change in spending will cause an initial increase in GDP and it also becomes income to someone else. (If I buy a new car, people who built and sold that car earn income equal to the price of the car.) What will these people do with their additional income? Well, they will spend some and save some. The amount that they spend increases GDP even more AND it also becomes income to someone else." This process then goes on and on . . . but why does it eventually stop or does it go on forever? If you reread the explanation of the multiplier process above you will get a clue as to why the process eventually stops. Notice that we said "What will these people do with their new income? Well, they will spend some and save some." People do not spend 100% of any additional income that they receive. the spend some and SAVE SOME. So that the additional spending is less than their increase in income. And when this additional spending becomes income to someone else, they sill save some and spend even a smaller amount. This will continue until the total change in savings is equal to the initial increase in spending. When this occurs there is nothing left to spend and the process stops. To understand the multiplier process we must gain a better understanding of how consumption and saving respond to changes in income. the table below is for a hypothetical economy. All values are in $ billions.
$ 0 $ 40 100 120 200 200 300 280 400 360 500 440
Notice that when income is equal to $ 0, there is still some consumption ($ 40 billion). this is called "autonomous consumption". It is consumption that is not related to income. Think about what a GDP of $ 0 represents. If GDP, or an economy's income, were equal to $0, this means that nothing was produced in this. If an economy does not produce a thing, would there still be some consumption? Yes, but how? they would consume goods that were saved from earlier periods. Of course, a GDP of $0 is a ridiculous concept, but there are two components to household consumption: (1) autonomous consumption that is not related to income, and (2) induced consumption or consumption that is directly related to income. Now, to understand,a and calculate, the multiplier, we need to complete the table. First we need some simplifying assumptions to make our model easier to understand:
Given these assumptions we can calculate savings (S). With these assumptions there are only two things that consumers can do with their income, spend it (C) or save it (S). So:
Therefore, we can calculate savings:
$ 0 $ 40 $ - 40 100 120 - 20 200 200 0 300 280 20 400 360 40 500 440 60 Average Propensity to Consume (APC) and Average Propensity to Save (APS) With this data we can calculate the APC and APS for each level of income. APC is the fraction of the economy's total income that is spent (consumed) and APS is the fraction of total income that is saved. When we calculate APC and APS we get:
$ 0 $ 40 $ - 40 100 120 - 20 1.2 - 0.2 200 200 0 1.0 0 300 280 20 0.93 .07 400 360 40 0.90 .10 500 440 60 0.88 .12 Notice that for each level of income: APC + APS = 1. Given our assumptions there are only two things that consumers can do with their income spend it or save it. If you add the fraction of the total income that is spent (APC) and the fraction of the total income that is saved (APS) we get all of our income, or 1. Can you think of anything else that we can do with our income besides spend it or save it? Many students will answer "invest it". But what does investment mean in economics? Investment is the accumulation of capital. "Capital" is a manufactured resource. Therefore, "investment" occurs when a carpenter buys a hammer or if McDonald's builds a new restaurant. Putting money into the stock market is NOT investment, it is savings. Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS) To understand the multiplier effect we need to know what happens to ADDITIONAL, or MARGINAL, income. Earlier we explained that the multiplier works "because an initial change in spending will cause an initial increase in GDP and it also becomes income to someone else. (If I buy a new car, people who built and sold that car earn income equal to the price of the car.) What will these people do with their additional income? With our consumption and savings data we can calculate the MPC and MPS for each level of income. MPC is the fraction of the economy's additional income that is spent (consumed) and APS is the fraction of additional income that is saved. "Marginal" means "additional" or "extra"
To calculate MPC and MPS select two levels of GDP or income. for example if income increases from $0 to $100, then consumption increases from $40 to 120. Therefore if income increases from $0 to $100 then the change in income is $100 and the change in consumption is $80. MPC is then equal to 0.8.
If you do the same thing for MPS you will get MPS = 0.2.
$ 0 $ 40 $ - 40 100 120 - 20 1.2 - 0.2 0.8 0.2 200 200 0 1.0 0 0.8 0.2 300 280 20 0.93 .07 0.8 0.2 400 360 40 0.90 .10 0.8 0.2 500 440 60 0.88 .12 0.8 0.2 If you remember your 8th grade math you would recognize that our formula for MPC is actually the slope of the consumption graph.
And the same is true for MPS:
One last item needs to be discussed: are MPC and MPS really constant? Note that in our table MPS equals 0.8 for all income levels and MPS equals 0.2. This means that if you get a raise (or additional income) of $1000 you would spend $800 of the raise (0.8 x 1000 = $800) and you would save $200 of it (0.2 x $1000 = $200). But is the fraction of additional income that is spent and saved really constant for all levels of income? Let's assume that I am going to give two families $10,000 in additional income. So I go to the housing projects in Chicago and find a poor family and give them $10,000 and I fly to the state of Washington and find Bill Gates (probably the richest person in the world) and give him $10,000. Would they both spend and save the same fraction of this additional income? No, the poor family would most likely spend the whole $10,000 and Bill Gates would probably spend nothing of the addition income. So the MPC of the poor family would be very high, or equal to 1, and the MPC of Bill Gates would be very low, or equal to 0. So as GDP or income increases, MPC should get smaller, or decrease, and MPS increases. This means the slope of the consumption graph should get smaller (flattens out) as GDP increases. We will assume that the MPC is constant in this course. that way we can use straight line consumption graphs and we can find the MPC by finding its slope. How Does the Multiplier Work: A Numerical ExampleGiven our simplifying assumptions we have an economy with only consumers and businesses. Therefore:
GDP = C + I Now let's assume that in this economy (let's say that it represents the Chicago area) a new stadium worth $20 million is built. What is the total impact of this investment on the economy? Well, if GDP is the total market value of all final goods and services produced in an economy in one year , then building this $20 million stadium will increase GDP initially by $20.
GDP = Income = C + I + 20 + 20 But when $20 is spent (and therefore $20 is produced) $20 is also earned as income to those who did the producing. so income also increases by $20. What do these people do with this additional income? Well, they spend a part and save a part. How much do they spend and save? What concept tells us the change in consumption that results from additional income? . . MPC !
So if incomes go up by $20, consumption will increase by $16 and the change in S = $4 So we get the following
GDP = Income = C + I + 20 + 20 + 16 +16 And GDP has gone up by an additional $16, but so has income. What will they do with this income? They will spend 80% (MPC=0.8) of it and save 20% (MPS=0.2). So we get the following:
GDP = Income = C + I + 20 + 20 + 16 +16 + 4 + 12.8 + 12.8 + 3.2 And GDP has increased by $12.8 and so has income, part of which will be spent and part saved. So consumption and GDP increase by $10.24 (0.8 x 12.8) and saving increases by 2.56 (0.2 x 12.8).
GDP = Income = C + I + 20 + 20 + 16 +16 + 4 + 12.8 + 12.8 + 3.2 + 10.24 + 10.24 + 2.56 This process will go on and on. When will it stop? If we add up all that has been saved and it equals 20, ( 4 + 3.2 + 2.56 + ...+...+...+...= 20) then there is nothing left to spend and the process stops. If you do this you will get the following total changes:
GDP = Income = C + I + 20 + 20 + 16 +16 + 4 + 12.8 + 12.8 + 3.2 + 10.24 + 10.24 + 2.56 total change total change total change + 100 + 80 + 20 + 20 So with an initial increase in spending of $20, GDP increases by $100. The most important formula for you to learn is:
So using our data we get:
change in GDP initial change in spending multiplier Graphically -- how does the multiplier work? a. THIS IS IMPORTANT! FROM TEXTBOOK (12.1) To see the multiplier in reverse read: : artbuchwaldmultiplier.htm multiplier and marginal propensities (slopes) a. Fiscal Policy and the Multiplier EffectNow let's add government to our model.
GDP = C + I + G Use these graphs to answer the questions that follow
OPTIONAL: Marginal Propensities to Consume and to Save The Government Expenditures Multiplier We know that a small initial change in spending will result in a multiplied effect on total spending in the economy, or:
So to answer question # 5 above we have:
If we knew what the multiplier was, we could easily calculate the change in government spending needed to increase GDP by $100 and achieve full employment.
So:
And:
and the increase in government spending needed to increase GDP by $100, and therefore achieve full employment, is $20.
The Multiplier and Marginal Propensities Notice that the size of the multiplier is inversely related to the size of the MPS. If the MPS is larger, the multiplier is smaller. This should make sense to you if you recall how the multiplier works. We said: "an initial change in spending will cause an initial increase in GDP and it also becomes income to someone else. (If I buy a new car, people who built and sold that car earn income equal to the price of the car.) What will these people do with their additional income? Well, they will spend some and save some.The amount that they spend increases GDP even more AND it also becomes income to someone else." So. if the MPS is larger (and the MPC is smaller) then the amount of additional income that is spent will be smaller and this will cause a smaller increase in GDP and a smaller increase in income to somebody else. Any time that more is saved and less is spent, GDP goes up by less. You may want to try different MPC's and MPS's and see if this is true using the formulas below:
The Multiplier Graphically How does the multiplier effect look on our AS-AD graph? Here is our initial graph:
Review of Important Formulas
The Lump-Sum Tax Multiplier There are three fiscal policy tools:
Here, let's use the same data that we have been using to see by HOW MUCH taxes should be changed when using fiscal policy. Use these graphs to answer the questions that follow
ANSWERS:
We know that a small initial change in spending will result in a multiplied effect on total spending in the economy, or:
So to answer question # 5 above we have:
If we knew what the lump-sum tax multiplier was, we could easily calculate the change in taxes needed to increase GDP by $100 and achieve full employment. First, what is a "lump-sum tax"? To make things easier for us we will discuss "lump-sum taxes" rather then the much more common income tax. A lump-sum tax is a "tax per person" and it does not change with income. for example if the lump-sum tax was $500 per person I would have to pay $2000 for my family of four regardless of my income. Next, we know that if taxes are cut, this will increase disposable income and therefore increase consumption: TThe question we have here is HOW MUCH? Let's say they decrease taxes by $25. this then will increase disposable income (spendable income) by $25. If consumers have an additional $25 to spend consumption will go up by how much? TWhat tells us the change in consumption that results from a change in income? . . . MPC!!! change in consumption = (0.8) x ($25) change in consumption = $20 So what happens to GDP with the multiplier effect?
change in GDP So when we cut taxes by $25, GDP increased by $100. What is the lump-sum tax multiplier?
So the lump sum tax multiplier is equal to -4. There are two ways to calculate the lump-sum tax multiplier:
and The lump-sum tax multiplier is always negative and So in this example our simple multiplier is:
So the lump-sum tax multiplier is -4. Fiscal Policy and the Balanced Budget Multiplier There are three fiscal policy tools:
What happens if the government changes BOTH government spending AND taxes by the SAME AMOUNT And in the SAME DIRECTION? We call this a "balanced-budget change". IT DOES NOT BALANCE THE FEDERAL BUDGET, but it doesn't make it any more unbalanced. If there is high unemployment and the government uses expasionary fiscal policy to try to reduce the unemployment they would increase government spending and/or decrease taxes. If they do this, spending goes up and tax revenues go down so this would lean to a budget deficit where they are spending more than they take in as taxes. Many people do not what the government to deficit spend. So let's go back to our example and see what the government can do to reduce unemployment without creating a (larger) deficit. Use these graphs to answer the questions that follow.
ANSWERS:
So let's go back to our example and see what the government can do to reduce unemployment without creating a (larger) deficit. What balanced-budget change (changing both government spending and taxes by the same amount and in the same direction) could the government undertake to increase GDP in this economy by $100 and thereby achieve full employment?
(change G and T by ?) What would happen if we increase G by $100 AND increase T by $100? If we increase G, this will increase GDP, but if we increase T, this will decrease GDP. If we do both, what happens? . . . It depends on HOW MUCH GDP changes. So lets increase G and T both by $100. What happens? Increase G by $100:
Increase T by $100:
Back to our example: What balanced-budget change (changing both government spending and taxes by the same amount and in the same direction) could the government undertake to increase GDP in this economy by $100 and thereby achieve full employment? So, if the government does both, GDP will go up by $500 and down by $400 for a net change of What is the balanced-budget multiplier?
(change G and T by $100) The Multiplier with Changes in the Price Level We have been assuming that the price level does not change as AD increases (see graph). But in the real world as GDP increases and approaches the full employment level of output the price level will begin to rise and resource costs increase. How does this inflation, which results from an increase in AD, affect the size of the multiplier? Or, what happens to the change in government spending needed to achieve full employment if we allow for inflation? Without inflation, and with an MPC of 0.8, if we increase government spending by $20 then GDP will increase by $100. the multiplier is 4. This will shift AD from AD1 to AD2 in both graphs above. In graph (a) without inflation the equilibrium GDP increases from $400 to $500. But in graph (b) with inflation the same horizontal shift in AD increases GDP from $400 to only $460. From the same change in government spending ($20) GDP increases a small amount. the multiplier is smaller. To calculate the multiplier with changes in the price level you need to know the initial change in spending ($20 in our example) and the resulting total change in GDP ($60 from graph b above).
The Complex Multiplier We have learned that in our simple model with no government, no inflation, and no foreign sector that the size of the multiplier is directly related to the MPC and inversely related to the MPS. In our simple model there are only two things that can be done with additional income: it can be spent or saved. the more that is NOT SPENT (saved) the smaller the change in GDP that results form a change in spending (i.e. the smaller the multiplier). But in the real world there are more things to do with additional income than just spend it or SAVE it. You could also give it to the government as TAXES or spend it on IMPORTS. These last three are LEAKAGES from the income-expenditure stream which means they are income that we don't spend on our GDP so they don't generate additional income and contribute to the multiplier.
With more leakages, less additional spending is generated from an initial injection of spending, so the multiplier is smaller. SIMPLE MULTIPLIER So in the real world there are more leakages from the income-expenditure stream and therefore the multiplier in the real-world is smaller than the simple multiplier that we will use most often in this class. Discretionary Fiscal Policy (pp. 244-248)
Definition: Discretionary Fiscal Policy A deliberate changes in taxes (tax rates) and government spending by Congress to promote full-employment price stability and economic growth. A. Discretionary Fiscal Policy and Multipliers Non-discretionary Fiscal Policy: Built-in Stabilizers (pp. 248-253)
Problems, Criticisms, and Complications (pp. 253-256)
Fiscal Policy in the Open Economy (pp. 256-257)
Supply-Side Fiscal Policy and the Multiplier (pp. 257-258) A. What is "Supply-Side FP" ?1. The contention that tax reductions will also shift the aggregate supply curve to the right. What fiscal policy actions would combat a recession?If recession threatens, the central bank uses an expansionary monetary policy to increase the supply of money, increase the quantity of loans, reduce interest rates, and shift aggregate demand to the right.
Which of the following is the appropriate fiscal policy during a recession quizlet?If the economy is in a recession, the most appropriate fiscal policy would be to: increase government spending and cut taxes, thus running a higher budget deficit.
What fiscal policy actions would combat the recession quizlet?Which of the following fiscal actions will have the best impact on correcting an economy in mild recession? Increase Government purchases of goods and services. This policy involves increasing government purchases, decreasing taxes and increasing transfer payments.
What is an appropriate fiscal policy for a severe recession?The expansionary fiscal policy will be appropriate for fighting for a severe recession. Severe recession is the condition of when GDP reduces by more than ten percent than the base year. For this condition, the government tries to increase the GDP by using expansionary fiscal policy.
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An appropriate fiscal policy to combat a recession would be to increase which of the following?
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