Fiscal Policy and the Multiplier Consider an economy in which the marginal prope

Question

Fiscal Policy and the Multiplier

Consider an economy in which the marginal propensity to consume is 0.8 and GDP is currently at 12,000.

            a) The government wishes to increase GDP to 13,000, and it is considering changing only one of its fiscal tools: 1) government purchases, 2) taxes, or 3) transfer payments. How much would the government have to change each of these fiscal policy tools in order achieve its goal? (Use the simple spending multiplier for this part and below.)

            b) Suppose instead that the government wishes to reduce GDP to 10,000 and again, it is considering using only one of its three available fiscal policy tools. How much would it change each of these fiscal tools to achieve its goal?

            c) Suppose instead that the government wished to raise GDP to 13,000, but the increase in government purchases would have to be matched by an equal increase in taxes. How much would they have to increase both to achieve this goal?  

Explanation / Answer

1)A [GOV SPENDING MULTIPLIER] is change in Y/ change in G. Formula for this is
change in Y/change in G= 1/1-MPC.
-This would be (13,000-12,000)/ change in G = 1/1-.8.
-Simplifies to 1,000/change in G =5.----> change in G =200.
-Increase of 200 to G increases Y by 1000 so multiplier is 5
[TAX MULTIPLIER] is change in Y/change in T. Formula for this is
change in Y/change in G = -MPC/1-MPC
-This would be (13,000-12,000)/change in T = -.8/1-.8
-Simplifies to 1,000/change in T = -4 ----> change in T= -250
- Decrease of 250 in T increases Y by 1000 so multiplier is -4
[TRANSFERS MULTIPLIER] is change in Y/ change in transfer payments. Formula for this is change in Y/change in transfer payments = MPC/1-MPC.
-This would be (13,000-12,000)/ change in transfers =.8/1-.8
-Simplifies to 1000/change in transfers = 4----> change in transfers = 250
-Increase of 250 in transfers causes increase of 1000 in Y so multiplier is 4
B.) Using same formulas as above.
[GOV SPENDING] (10,000-12,000)/change in G= 1/1-.8.
-Simplifies to -2000/change in G=5---->change in G= -400 and multiplier is 5
[TAXES] -2000,/change in T = -.8/.2
-Simplifies to -2000/change in T = -4----> change in T= 500 and multiplier is -4
[TRANSFERS] -2000/change in transfers = .8/1-.8
-Simplifies to -2000/change in transfers = 4 -----> change in transfers = -500 and multiplier is 4
C)Since a spending increase has to be matched by an EQUAL increase in taxes, in this case, change in G = change in T.
- We can just use our answer from A which says we need a change in G of 200,
- The change in T would be the same amount, 200

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