6- Aggregate Expenditure and the Multiplier

Question 1

What does the multiplier measure?

Answer 1

The magnitude of change in GDP given a change in AE.

Question 2

What does the simple multiplier measure?

Answer 2

The change in equilibrium GDP that occurs in response to a change in autonomous spending at constant price level.

Question 3

Why is it called the ‘simple’ multiplier?

Answer 3

Because we assume that the price level and interest rates are fixed.

Question 4

What does the size of the multiplier depend on?

Answer 4

The marginal propensity to spend, c.
High c= high multiplier

Question 5

What symbol is the multiplier denoted?

Answer 5

K

Question 6

Multiplier equation

Answer 6

= 1/1-c

Question 7

How to derive the simple multiplier?

Answer 7

Look at book

Question 8

Relationship between mpc and the multiplier?

Answer 8

As the model is simple, the mpc=c (propensity to spend) so large determinant of the multiplier.

Question 9

Fiscal policy definition

Answer 9

The use of government’s taxing and spending powers to affect the level of GDP/

Question 10

How do we advance a simple/closed economy into an open economy?

Answer 10

Add government and foreign sectors.

Question 11

Why is gov spending exogenous?

Answer 11

Gov spends whatever it wants regardless of GDP.

Question 12

Net taxes definition

Answer 12

= Total tax revenues - total transfer payments

Question 13

Budget balance

Answer 13

Difference between total gov revenue and total gov spending.
Or (net taxes- gov spending)
= T-G

Question 14

Budget surplus

Answer 14

• When tax revenue > spending.
• National debt will be reduced.

Question 15

Budget deficit

Answer 15

• Gov must borrow to cover its deficit.
• National debt will rise.

Question 16

What are tax rates treated as?
What is the effect on how tax revenues are treated?

Answer 16

• Tax rates are treated as exogenous.
• This makes tax revenues endogenous.

Question 17

Effect of GDP rise of tax revenue?

Answer 17

As GDP rises, tax revenues assumed to rise.

Question 18

Budget balance in a recession?

Answer 18

• Budget deficit in a recession due to lower incomes, profits, higher transfer payments. etc.

Question 19

Tax (or net tax function)

Answer 19

T = t0 + tY
where t= marginal propensity to tax (mpt)
t0= autonomous taxes

Question 20

Marginal propensity to tax equation

Answer 20

= change in taxes/ change in income

Question 21

Autonomous taxes

Answer 21

Taxes not related to income, e.g. VAT.

Question 22

AE model now the government sector has been added?

Answer 22

AE= Y= C + I + G

Question 23

Consumption function as a result of the introduction of the government sector

Answer 23

C = a + b(Y-T)

Question 24

Equilibrium income now gov sector has been added

Answer 24

Check book

Question 25

Multiplier now gov sector included?

Answer 25

= 1/(1-b(1-t))

Question 26

Effect on multiplier now gov sector included?

Answer 26

As t>0.
The multiplier is now smaller than it was before gov sector came in.

Question 27

Effect of addition of G on AE (C+I+G) diagram

Answer 27

• 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.

Question 28

Effect of a higher marginal rate of income tax (t) on AE slope?

Answer 28

It will become flatter.
Higher tax rate, lower Y.

Question 29

Limitations of fiscal policy

Answer 29

• 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.