6- Aggregate Expenditure and the Multiplier Flashcards
What does the multiplier measure?
The magnitude of change in GDP given a change in AE.
What does the simple multiplier measure?
The change in equilibrium GDP that occurs in response to a change in autonomous spending at constant price level.
Why is it called the ‘simple’ multiplier?
Because we assume that the price level and interest rates are fixed.
What does the size of the multiplier depend on?
The marginal propensity to spend, c.
High c= high multiplier
What symbol is the multiplier denoted?
K
Multiplier equation
= 1/1-c
How to derive the simple multiplier?
Look at book
Relationship between mpc and the multiplier?
As the model is simple, the mpc=c (propensity to spend) so large determinant of the multiplier.
Fiscal policy definition
The use of government’s taxing and spending powers to affect the level of GDP/
How do we advance a simple/closed economy into an open economy?
Add government and foreign sectors.
Why is gov spending exogenous?
Gov spends whatever it wants regardless of GDP.
Net taxes definition
= Total tax revenues - total transfer payments
Budget balance
Difference between total gov revenue and total gov spending.
Or (net taxes- gov spending)
= T-G
Budget surplus
- When tax revenue > spending.
- National debt will be reduced.
Budget deficit
- Gov must borrow to cover its deficit.
- National debt will rise.
What are tax rates treated as?
What is the effect on how tax revenues are treated?
- Tax rates are treated as exogenous.
- This makes tax revenues endogenous.
Effect of GDP rise of tax revenue?
As GDP rises, tax revenues assumed to rise.
Budget balance in a recession?
- Budget deficit in a recession due to lower incomes, profits, higher transfer payments. etc.
Tax (or net tax function)
T = t0 + tY
where t= marginal propensity to tax (mpt)
t0= autonomous taxes
Marginal propensity to tax equation
= change in taxes/ change in income
Autonomous taxes
Taxes not related to income, e.g. VAT.
AE model now the government sector has been added?
AE= Y= C + I + G
Consumption function as a result of the introduction of the government sector
C = a + b(Y-T)
Equilibrium income now gov sector has been added
Check book
Multiplier now gov sector included?
= 1/(1-b(1-t))
Effect on multiplier now gov sector included?
As t>0.
The multiplier is now smaller than it was before gov sector came in.
Effect of addition of G on AE (C+I+G) diagram
- The slope of the C+I+G line is smaller than before because taxes are a reduction of household spending.
- The intercept now includes t0 and G.
- Gradient = b(1-t)- the marginal propensity to consume out of gross income- any change in b or t will cause line to swivel.
Effect of a higher marginal rate of income tax (t) on AE slope?
It will become flatter.
Higher tax rate, lower Y.
Limitations of fiscal policy
- Time lags: inside lags (recognition lag +decision lag) and the outside lag means swift policy changes are rarely possible
- Forecasting accuracy is important, but impossible
- Public investment is irreversible ñ once you have started to build a hospital it makes no sense not to finish it!
- Financing issues: if the budget deficit is already large as in 2008 is it sensible to increase it further?
- Depends on size of country and financing history
- The EU tries to limit the size of budget deficits to 3% of GDP and the stock of debt outstanding to 60% of GDP.
- These limits are not sensible, they restrict active policy and should not be the same for all countries.
