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Fiscal Policy
Lecture 13


Multiplier Effect


  1. Keynesian economics – gov. should intervene and help pick up the economy

    1. Why?

      1. Economic growth

        1. Real GDP is growing

        2. Real GDO per capita is growing

        3. Society produces more goods and services

        4. Society has higher income

        5. Gov. collects more tax revenues

        6. Unemployment rate falls

      2. Difficult to measure condition of the economy

        1. Index of Leading Economic Indicators

          1. Stock prices

          2. Building permits

          3. Consumer expectations, etc.

  2. Multiplier Effect – change in income (or GDP) when something changes like investment, gov. spending, or net exports

    1. Marginal Propensity to Consume (MPC) – if income increases by $1, then MPC is amount consumers spend

    2. Marginal Propensity to Save (MPS) – if income increases by $1, then MPS is amount consumers save

    3. Note – use marginal, because consumption and savings may be different for different income levels

    4. Thus, MPC + MPS =1

    5. Example: Computer company invests $1,000,000 into new building and hires more workers

      • Let MPC = 0.9; thus, MPS = 0.1

Round Income Consumption Savings Notation
Round 1 $1,000,000.00 $900,000.00 $100,000.00 DI
Round 2 $900,000.00 $810,000.00 $90,000.00 DI (MPC)
Round 3 $810,000.00 $729,000.00 $81,000.00 DI (MPC)2

Infinity $10,000,000.00 $900,000.00 $1,000,000.00
    1. Round 1: The construction and computer company employees earn $1,000,000. This is income; thus they spend 90% and save 10%

      • They buy more houses, cars, clothes, etc.

    2. Round 2: Income increases by $900,000 for the businesses that experienced increased spending

      • Employees spend 90% and save 10%; spending creates even more income

    3. Round 3: These new employees spend more because income went up by $810,000. Thus, they spend 90% and save 10%

      • Creates $729,000 in new income.

    4. We have an infinite series

Equation 1

Equation 2

Equation 3

    1. Example – the change in investment is $1,000,000 and MPC = 0.9

Equation 4 

    1. Economists estimate the multiplier to be around 2

    2. Assumptions

      1. Savings are a leakage; implies we have a consumer economy

      2. Savings are channeled into banks, which loan to borrowers

        • The source of the investment funds

      3. Taxes go up with the incomes

        • Gov. spends more, building more roads, schools, prisons, etc.

    3. Note – Multipliers can work in reverse.

      1. Economist do not talk about this!

      2. Example

      3. Company shuts down, laying off workers

      4. Workers have less income

      5. They spend less, causing other businesses to earn losses; they then lay off workers

      6. Paradox of Thrift

      7. Note – government tax collections could decrease; usually rare for government to reduce government spending; thus, taxes usually increase

Fiscal Policy


Fiscal Policy – government changes taxes (T) and/or government spending (G) to move economy to full employment

  1. Gov. budget is balanced, thus G = T

  2. Budget deficit, G > T; government spends more than what it collects as taxes

    • Gov. debt increases

  3. Budget surplus, T > G; government spends less than what it collects as taxes

    • Gov. pays down the debt

  4. Expansionary fiscal policy – gov. uses this policy to move an economy out of an recession

    1. Gov. increases G or lowers T

    2. Households have more income; thus they spend it.

    3. G > T; expands the economy

Aggreate Demand increases and shifts right 

      1. Amount of shift – Use multiplier

      2. Gov. spending

      3. Example: Let GDPFE = $14 trillion, GDP = $10 trillion, and the multiplier is 2, then

Equation 5 

      1. Taxes are a little more tricky

      2. Remember – gov. lowers taxes, allowing households to keep more income

        • MPC is the proportion spent while MPS is the proportion saved

      3. Example: Let GDPFE = $14 trillion, GDP = $10 trillion, the multiplier is 2, and MPC = 0.95, then

Equation 6

      1. Remember – taxes have to decrease

      2. Consequently, government has to lower taxes even lower than to increase government spending to move the economy to the same point

      3. Note – This may not work

        1. 2008 Financial Crisis

        2. Gov. lowered taxes

        3. Households may have kept the money and saved it

        4. The tax reduction was not put back into the economy

    1. Contractionary fiscal policy – gov. uses this policy to slow down the economy, if it is growing too fast

      1. Gov. increases taxes and/or reduces gov. spending

      2. Note – gov. rarely decreases spending

      3. Thus, T > G; Removes money from the economy

Aggregate Demand decreases and shifts left

      1. Amount of the shift

      2. Example: Let GDPFE = $14 trillion, GDP = $15 trillion, and the multiplier is 2, then

Equation 7

      1. Or government increases taxes

      2. Let the MPC = 0.95, then

Equation 8

Problems with Fiscal Policy


  1. Problems with fiscal policy

    1. Gov. tends to be filled with Keynesian economists

      • Pro-government

    2. Time lags

      1. Information lag – takes times to collect information

      2. Administrative lag – takes time to develop policy

        1. Central bank – quick; within a month

        2. Congress and the President – range from quick to slow

      3. Impact lag – takes times for policy to impact economy

      4. Example GDP data takes 3 months to compute

        1. Recession is two consecutive negative growth for GDP

        2. Takes 9 months to determine if the economy is in a recession

        3. 6 to 12 months for Congress and President to pass

        4. 6 to 12 months before impact on economy

        5. Economy could already be growing again before fiscal policy kicks in

    3. Political business cycle – Politicians want to be re-elected

      1. Reduce taxes and/or increase government spending before election

      2. Politicians are usually “tossed” out during downturns in economy

    4. State and local governments are independent

      • Federal gov. could lower taxes, while state and local governments increase taxes

    5. Crowding out Effect

      1. Investors buying U.S. government bonds cannot buy stocks and corporate bonds

      2. Gov. increases its debt quickly

      3. Causes interest rates to increase

      4. Businesses reduce their investment because of higher interest rates

    6. Government keeps increasing its size and scope

  2. Growing debt

    1. As the debt increases, government pays more interest on the debt

    2. Future generations are stuck with the debt

      • Could mean future tax increases

    3. Foreigners invest in gov. debt

      • Could lead to an outflow of money, if foreigners stop investing and cash in their bonds

    4. Gov. may force the central bank to buy debt

      1. Leads to inflation

      2. Note – central bank and government could be independent

      3. Monetizing the debt

        1. The federal government runs up a debt, increasing the interest rates

        2. The central bank buys this debt to reduce interest rates


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