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The Multiplier Effect
Sooooooo…
1.) Full employment - about 5% unemployment
2.) Stability (Prices)
3.) Economic growth
4.) Balance of Payments Equilibrium
- about 2% inflation- about 3% growth (7% in China)
Keep trade deficits low, but no
AD = C + I + G + (X – M) These are our Macroeconomic goals…
This is our Macroeconomic equation…
And the G in the equation is the government attempting to smooth out the business cycle with it’s policy…
Expansionary Fiscal Policy
Contractionary Fiscal Policy
And there are two ways to enact either 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 accomplished…
Discretionary Fiscal Policy
Automatic Stabilizers
And there are the resources used to do this…
Keep trade deficits low, but no
AD = C + I + G + (X – M)
Federal Budget
And there are the resources used to do this…
Which comes from either…
Taxes
Borrowing
Soooooooooooo…….
The next question is how effective are these policies…
I work for the Government!
Big G ManThis Man represents the
Government in our economy so we will call him…
Let’s look at our country’s AD!
Fiscal Policy Effectiveness Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRAS
Big G Man
Oh No! the AD is below the long
run equilibrium!
Fiscal Policy Effectiveness Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRAS
I am sad for my country
Big G Man
Fiscal Policy Effectiveness Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRASLet’s check the GDP spending
numbers
AD = Y1 = 90 billion current GDP
AD =YN = 100 billion GDP GoalBig G Man
Fiscal Policy Effectiveness Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRAS
AD = Y1 = 90 billion current GDP
AD =YN = 100 billion GDP GoalBig G Man
Our country has a $10 billion shortfall in AD
Fiscal Policy Effectiveness Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRAS
AD = Y1 = 90 billion current GDP
AD =YN = 100 billion GDP GoalBig G Man
Ok simply, the government can just spend $10 billion to
fill this hole!
Fiscal Policy Effectiveness Example
Fiscal Policy Effectiveness Example
G
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRASOk simply, the government can just spend $10 billion to
fill this hole!
$10 billion
Spending
= AD$10 billion
Big G Man
Fiscal Policy Effectiveness Example
G
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRASOk simply, the government can just spend $10 billion to
fill this hole!
$10 billion
Spending
= AD$10 billion
Big G Man
Fiscal Policy Effectiveness Example
G
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRASOk simply, the government can just spend $10 billion to
fill this hole!
$10 billion
Spending
= AD$10 billion
Big G Man
This doesn’t work
Fiscal Policy Effectiveness Example
G
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRASOk simply, the government can just spend $10 billion to
fill this hole!
$10 billion
Spending
= AD$10 billion
Big G Man
It doesn’t equal this, instead it equal…
G
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRASOk simply, the government can just spend $10 billion to
fill this hole!
$10 billion
Spending
= AD$50 billion
AD1
Y2
P2
Big G Man If MPC
is 0.8 ( )
Fiscal Policy Effectiveness Example
This
G
Price
level
GDP
SRAS
PE
YN
LRASOh no! the economy is overheating and now
we have too much inflation!
$10 billion
Spending
= AD$50 billion
AD1
Y2
P2
= Inflation
Fiscal Policy Effectiveness Example
G
Price
level
GDP
SRAS
PE
YN
LRAS
What did I do wrong?
$10 billion
Spending
= AD$50 billion
AD1
Y2
P2
= Inflation
Fiscal Policy Effectiveness Example
AD = C + I + G + (X – M)
Government spending
Price
level
GDP
AD
SRAS
PE
LRAS
YN Y1
P1
AD1
- Government spends
more in the economy
and makes jobs, people
have more money and
increase consumption.
Fiscal Policy Effectiveness Example
Must add a multiplier
effect
AD = C + I + G + (X – M)
Taxes
Price
level
GDP
AD
SRAS
PE
LRAS
YN Y1
P1
AD1
- Lower taxes means
people have more
money to use for
consumption and also
businesses have more
money to increase
investment spending.
Fiscal Policy Effectiveness Example
Must add a multiplier
effect
- the number of times a rise in national income exceeds the rise in injections 注入of demand that caused it
The Multiplier
effect
the additional shifts in AD
that result when fiscal policy
increases income and thereby
increases consumer spending (C)
Reworded definition: 换句话说
Each $1 increase in G can generate more than a $1 increase in AD.
Fiscal Policy Effectiveness
The Multiplier
effect
1
1 – MPC=
- the number of times a rise in national income exceeds the rise in injections 注入of demand that caused it
G spending
Equation:
or1
MPS=
Tax Equation:or
Tax Equation:or
The Multiplier Effect
1.) The government buys airplanes from a domestic
manufacturer.
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
level
GDP
AD
Multiplier Effect Example
- the fraction of extra income that households consumes rather than save
The Multiplier
effectMarginal
Propensity to
Consume
(MPC)Example:
1.) if MPC = 0.8
2.) if income rises by $100
3.) then C consumption rises $80
The size of the multiplier depends on MPC.
Fiscal Policy Effectiveness
Marginal
Propensity to
Consume
(MPC)
The size of the multiplier depends on MPC.
if MPC = 0.5 Multiplier = 2
if MPC = 0.75 Multiplier = 4
if MPC = 0.9 Multiplier = 10
Example sizes:
Fiscal Policy Effectiveness
- the fraction of extra income that households saves rather than consumes
Marginal
Propensity to
Consume
(MPS)
Marginal
Propensity to
Save
Example:
1.) if MPS = 0.2
2.) if income rises by $100
2.) then C consumption rises $80
Fiscal Policy Effectiveness
I will spend more G money and make a
new bridge!
Big G Man
Fiscal Policy Effectiveness Example
So I need to hire some workers to
do it.
Big G Man
Fiscal Policy Effectiveness Example
Big G Man
给钱 做桥
G$10 billion
Spending=
AD$10 billion + …
Workers
Fiscal Policy Effectiveness Example
Workers
Some of this money with will spend
(MPC) = 0.8
We have earned some wages!
Some of this money we will save (MPS)
= 0.2
Fiscal Policy Effectiveness Example
Workers
Let’s buy some new dresses!
Fiscal Policy Effectiveness Example
Workers
给钱
Dress maker
做衣服
($10 billion)
$8 billion用钱
$2 billion存钱。
Fiscal Policy Effectiveness Example
Workers
给钱
Dress maker
做衣服
G$10 billion
Spending
+workers
$8 billion
Spending+ …
Fiscal Policy Effectiveness Example
Big G Man
$10 billion
Spending
+ …
Workers
+ +
Dress maker
+$8 billion
Spending
$6.4 billion
Spending
+ +…
Fiscal Policy Effectiveness Example
Big G Man
+ …
Workers
+ +
Dress maker
G$10 billion
Spending
+MPC = 0.8of each round of
income’s spending
1
1 – MPC=
Fiscal Policy Effectiveness Example
Big G Man
+ …
Workers
+ +
Dress maker
MPC = 0.8of each round of
income’s spending
1
1 – MPC= Multiplier
= 5
Fiscal Policy Effectiveness Example
Big G Man
+ …
Workers
+ +
Dress maker
G$10 billion
Spending
= AD$50 billion
x Multiplier
of 5
Fiscal Policy Effectiveness Example
A $10billion increase in G initially shifts AD to the right by $10billion.
The increase in Ycauses C to rise, which shifts ADfurther to the right.
Y
P
AD1
P1
AD2AD3
Y1 Y3Y2
$10 billion
The Multiplier Effect
AD = C + I + G + (X – M) Government
spending
Y = C + I + G + NX identity
Y = C + G I and NX do not change
Y = MPC Y + G because C = MPC Y
solved for Y1
1 – MPCY = G
The multiplier
Fiscal Policy Effectiveness
Marginal Propensity to Consume (MPC) Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRAS
Ok let’s try again!
Big G Man
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRASLet’s check the GDP spending
numbers
AD = Y1 = 90 billion current GDP
AD =YN = 100 billion GDP GoalBig G Man
Fiscal Policy Effectiveness Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRAS
AD = Y1 = 90 billion current GDP
AD =YN = 100 billion GDP GoalBig G Man
Our country has a $10 billion shortfall in AD
Fiscal Policy Effectiveness Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRAS
AD = Y1 = 90 billion current GDP
AD =YN = 100 billion GDP GoalBig G Man
If I know the MPC in my country is 0.8
Fiscal Policy Effectiveness Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRAS
Then I use that in this equation
1
1 – MPC=
= 1/1-0.8
= 1/0.2Big G Man
Fiscal Policy Effectiveness Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRAS
1
1 – MPC=
= 1/1-0.8
= 1/0.2
= 5
Big G Man
Now I know the multiplier!
Fiscal Policy Effectiveness Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRASI only have to spend $2 billion and that
will equal $10 billion in total spending!
AD = Y1 = 90 billion current GDP
AD =YN = 100 billion GDP GoalBig G Man
Fiscal Policy Effectiveness Example
Big G man
Price
level
GDP
AD
SRAS
PE
YN
LRAS
Hurry! Our Economy is saved!
Fiscal Policy Effectiveness Example
AD = C + I + G + (X – M)
Government spending
Price
level
GDP
AD
SRAS
PE
LRAS
YN Y1
P1
AD1
- Government spends
more in the economy
and makes jobs, people
have more money and
increase consumption.
Fiscal Policy Effectiveness Example
This has a multiplier…
AD = C + I + G + (X – M)
Taxes
Price
level
GDP
AD
SRAS
PE
LRAS
YN Y1
P1
AD1
- Lower taxes means
people have more
money to use for
consumption and also
businesses have more
money to increase
investment spending.
Fiscal Policy Effectiveness Example
This has a different
multiplier…
The Multiplier
effect
- the number of times a rise in national income exceeds the rise in injections 注入of demand that caused it
G spending
Equation:
or
Tax Equation:or
Tax Equation:or
MPC
1 – MPC=
MPC
MPS=
- MPC
1 – MPC=
- MPC
MPS=
Fiscal Policy Effectiveness
AD = C + I + G + (X – M) Taxes
Reduced taxes are not an injection of new money
It “frees’” up current income into more disposable income
Some is saved, some is spend, just like the Government Spending Multiplier but without the first injection of new money that is 100% spend.
Tax Multiplier Effect
1.) The government reduces income taxes for people
2.) People now have more disposable income
(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
level
GDP
AD
However it is one less round then government spending it is a smaller multiplier
Tax Multiplier Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRAS
AD = Y1 = 90 billion current GDP
AD =YN = 100 billion GDP GoalBig G Man
Our country has a $10 billion shortfall in AD
Tax Multiplier E ffect 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 Effect Example
Big G Man WorkersBoss of Workers
I will reduce all your taxes so you have more disposable
income
Tax Multiplier Effect Example
Big G Man WorkersBoss of Workers
Hurry! I might even hire new workers!
Tax Multiplier Effect Example
Big G Man WorkersBoss of Workers
Hurry! Now we can buy more dresses!
Tax Multiplier Effect Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRAS
AD = Y1 = 90 billion current GDP
AD =YN = 100 billion GDP GoalBig G Man
If I know the MPC in my country is 0.8
Tax Multiplier Effect Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRAS
AD = Y1 = 90 billion current GDP
AD =YN = 100 billion GDP GoalBig G Man
Our country has a $10 billion shortfall in AD
Tax Multiplier Effect Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRAS
Then I use that in this equation
MPC
1 – MPC=
= 0.8/1-0.8
= 0.8/0.2Big G Man
Tax Multiplier Effect Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRAS
MPC
1 – MPC=
= 0.8/1-0.8
= 0.8/0.2
= 4
Big G Man
Now I know the tax multiplier!
Tax Multiplier Effect Example
Price
level
GDP
AD
SRAS
PE
YNY1
P1
LRASI have to cut taxes by 2.5 billion to get $10
billion in total spending!
AD = Y1 = 90 billion current GDP
AD =YN = 100 billion GDP GoalBig G Man
Tax Multiplier Effect Example
Big G man
Price
level
GDP
AD
SRAS
PE
YN
LRAS
Hurry! Our Economy is saved!
Tax Multiplier Effect Example
The Multiplier
effect
1
1 – MPC=
- the number of times a rise in national income exceeds the rise in injections 注入of demand that caused it
G spending
Equation:
or1
MPS=
Tax Equation:or
Tax Equation:or
MPC
1 – MPC=
MPC
MPS=
- MPC
1 – MPC=
- MPC
MPS=
Fiscal Policy Effectiveness
So the Government can spend money and increase AD by a multiplier…
Or the Government can decrease taxes an increase AD by a multiplier…
So the Government spending has a bigger multiplier…
However…
Don’t forget the money isn’t free, it comes from the federal budget that has to be balanced, and if it’s in deficit this adds another problem.
The Multiplier Effect
3.1) Budget Deficit Problems
Crowding out: - Government spending and borrowing
that may fail to increase AD and hurts
排挤 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 排挤 private sector investment.
- Typically this deals with the increase of interest
rates due to attempting to sell more bonds to
finance debt.
So a quick example of this…
The Multiplier Effect
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
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) = 5
Answer: Increase G by $40billion
to shift AD by 5 x $40billion = $200billion
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.
Hope you understand!
Thank you!