The Multiplier Effect SFLS

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!


Price

level

GDP

AD

SRAS

PE

YNY1

P1

LRAS

I am sad for my country

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


Price

level

GDP

AD

SRAS

PE

YNY1

P1

LRAS



Our country has a $10 billion shortfall in AD


Price

level

GDP

AD

SRAS

PE

YNY1

P1

LRAS



Ok simply, the government can just spend $10 billion to

fill this hole!



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


G

Price

level

GDP

AD

SRAS

PE

YNY1

P1


fill this hole!

$10 billion

Spending

= AD$10 billion

Big G Man


G

Price

level

GDP

AD

SRAS

PE

YNY1

P1


fill this hole!

$10 billion

Spending

= AD$10 billion

Big G Man

This doesn’t work


G

Price

level

GDP

AD

SRAS

PE

YNY1

P1


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


fill this hole!

$10 billion

Spending

= AD$50 billion

AD1

Y2

P2

Big G Man If MPC

is 0.8 ( )


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


G

Price

level

GDP

SRAS

PE

YN

LRAS

What did I do wrong?

$10 billion

Spending

= AD$50 billion

AD1

Y2

P2

= Inflation


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.


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.


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=


G spending

Equation:

or1

MPS=

Tax Equation:or

Tax Equation:or


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.


Marginal

Propensity to

Consume

(MPC)

The size of the multiplier depends on MPC.

if MPC = 0.5 Multiplier = 2



Example sizes:


- 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


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

给钱做桥

G$10 billion

Spending=

AD$10 billion + …

Workers


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


Workers

Let’s buy some new dresses!


Workers

给钱

Dress maker

做衣服

($10 billion)

$8 billion用钱

$2 billion存钱。


Workers

给钱

Dress maker

做衣服

G$10 billion

Spending

+workers

$8 billion

Spending+ …


Big G Man

$10 billion

Spending

+ …

Workers

+ +

Dress maker

+$8 billion

Spending

$6.4 billion

Spending

+ +…


Big G Man

+ …

Workers

+ +

Dress maker

G$10 billion

Spending

+MPC = 0.8of each round of

income’s spending

1

1 – MPC=


Big G Man

+ …

Workers

+ +

Dress maker

MPC = 0.8of each round of

income’s spending

1

1 – MPC= Multiplier

= 5


Big G Man

+ …

Workers

+ +

Dress maker

G$10 billion

Spending

= AD$50 billion

x Multiplier

of 5


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


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


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




Price

level

GDP

AD

SRAS

PE

YNY1

P1

LRAS





Price

level

GDP

AD

SRAS

PE

YNY1

P1

LRAS



If I know the MPC in my country is 0.8


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


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!


Price

level

GDP

AD

SRAS

PE

YNY1

P1

LRASI only have to spend $2 billion and that

will equal $10 billion in total spending!




Big G man

Price

level

GDP

AD

SRAS

PE

YN

LRAS

Hurry! Our Economy is saved!


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.


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.


This has a different

multiplier…

The Multiplier

effect


G spending

Equation:

or

Tax Equation:or

Tax Equation:or

MPC

1 – MPC=

MPC

MPS=

- MPC

1 – MPC=

- MPC

MPS=


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




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



Hurry! I might even hire new workers!



Hurry! Now we can buy more dresses!


Price

level

GDP

AD

SRAS

PE

YNY1

P1

LRAS



If I know the MPC in my country is 0.8


Price

level

GDP

AD

SRAS

PE

YNY1

P1

LRAS





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


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!


Price

level

GDP

AD

SRAS

PE

YNY1

P1

LRASI have to cut taxes by 2.5 billion to get $10

billion in total spending!




Big G man

Price

level

GDP

AD

SRAS

PE

YN

LRAS

Hurry! Our Economy is saved!


The Multiplier

effect

1

1 – MPC=


G spending

Equation:

or1

MPS=

Tax Equation:or

Tax Equation:or

MPC

1 – MPC=

MPC

MPS=

- MPC

1 – MPC=

- MPC

MPS=


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.


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 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




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




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!

Education

The Multiplier Effect SFLS