CFA CFA Level 1 Econ on Multipliers and spending programs

Econ on Multipliers and spending programs

  • Author
    Posts
    • Up
      7
      ::

      Hi @pcunniff, you’ll need to check out L1 Reading 16 (monetary and fiscal policy) to brush up on the fiscal multiplier and budget multiplier concepts. This is a common ‘trick’ question for Econs section.

      OK, so we know a $10bn increase in taxes (revenue) is offset by $10bn spending on subsidies (expenditure), making the budget unchanged, assuming all else is constant.

      But the aggregate output (GDP) actually increases given the positive balanced budget multiplier.

      Here’s how: know that the Fiscal multiplier = 1 / [1-MPC(1-t)],

      where MPC = marginal propensity to consume, i.e., how much will the consumption increase with an increase in disposable income. Most of the time this number is less than 1 as people save something,

      t = tax rate

      To understand the fiscal multiplier, let’s see a simple numerical example:

      Say the government increase spending by $100. Let’s assume that the tax rate (t) is 25% and MPC for those who receive this money is 80%.

      So, a $100 increase in government spending increases disposable income by $100*(1-0.25) = $75. From this disposable income of $75, people will spend $75 *0.80 = $60. This $60 will become income for other people, and their disposable income will be $60*(1-0.25) = $45, out of which they will spend $45*0.80 = $36. This iterative process will continue until the extra disposable income created becomes nearly zero.

      In short, you can use the Fiscal Multiplier formula above and get 1 / (1-0.8(1-0.25)) = 2.5x. So $100 government spending increases the GDP by $250 in this example.

      Remember that even taxes have a multiplier effect on aggregate demand (AD). Say if government increases $100 in taxes to offset the initial spending in the same example above, using the same MPC of 80%, aggregate demand will initially reduce by $100*0.8 = $80. Using the same iterative process, we come up with a total AD reduction of $100 * 0.8 * 2.5 = $200.

      So you can see that the multiplier effect of spending is greater than taxes, i.e. $250 is greater than $200. So you can conclude that an increase in $100 government spending WITH a $100 tax increase has a net increase in aggregate demand of $50.

      Or to calculate it another way:

      the INITIAL increase in AD due to extra spending is $100.the INITIAL decrease in AD due to taxes is $80.So the total impact on output is (100-80) * fiscal multiplier of 2.5 = $50

Viewing 0 reply threads
  • You must be logged in to reply to this topic.