CFA CFA Level 1 Econ on Multipliers and spending programs

# Econ on Multipliers and spending programs

• Author
Posts
• Can someone help with this? Kaplan question and can’t seem to understand. Thanks much. Happy Hollidays!

Im confused why this answer is not B. Can you please explain? Can your explanation include math so I can wrap my head around the answer? The explanation is confusing. What is the multiplier? That would be helpful to maybe break that down otherwise this is very confusing to me. Please advise and Merry Christmas

A government enacts a program to subsidize farmers with an expansive spending program of \$10 billion. At the same time, the government enacts a \$10 billion tax increase over the same period. Which of the following statements best describes the impact on aggregate demand?

A) Lower growth because the tax increase will have a greater effect.

B) No effect because the tax and spending effects just offset each other.

C) Higher growth because the spending increase will have a greater effect.

Explanation

The amount of the spending program exactly offsets the amount of the tax increase, leaving the budget unaffected. The multiplier for government spending is greater than the multiplier for a tax increase. Therefore, the balanced budget multiplier is positive. All of the government spending enters the economy as increased expenditure, whereas spending is reduced by only a portion of the tax increase. (LOS 16.p)

• 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 1 reply thread
• You must be logged in to reply to this topic.