Topic 3 - The multiplier, government and foreign sectors

Question 1

3.01 - What is the multiplier effect?

Answer 1

It is the result that a change in investment spending (or other autonomous spending) gives rise to a larger change in the outcome -income level.

Question 2

3.02 - What is the multiplier?

Answer 2

It is the ratio of a change in equilibrium GDP to the original change in investment spending (or other autonomous spending) that caused that change in GDP. It is the change in real GDP / change in investment.

Question 3

3.03 - What is the theory behind the multiplier?

Answer 3

That a change in income of $5bn, will bring about a 0.75 increase in consumption and a 0.25 increase in saving. The 0.75 put back into the economy, adds $3.75bn, which is then split again. So the effect of the $5bn is multiplied.

Question 4

3.04 - We have worked with a multiplier of 4, but what would cause this to change?

Answer 4

If the MPS was greater or smaller than 0.25, the amount of the multiplier would change, ie. if the MPS was 0.33, the multiplier would be 3 and if it was 0.10 it would be 10.

Question 5

3.05 - What is the ‘initial change in spending’ and how is it diagrammatically represented?

Answer 5

It is the first ‘income’ added back into the economy and is usually associated with investment spending. It refers to an upshift or downshift in the aggregate expenditures schedule due to an upshift or downshift of one of its components.

Question 6

3.06 - What is the relationship between the MPS and the multiplier? and what is it called?

Answer 6

It is the simple multiplier - 1/MPS = 1/(1-MPC)
It is the multiplier based on the private, closed model of the economy, where the 1/MPS formulation reflects only the leakage of saving.

Question 7

3.07 - What is the paradox of thrift?

Answer 7

That is the paradox that if society attempts to save more, it may end up actually saving the same or even less, as a result of the multiple decline in the equilibrium GDP caused by the withdrawal of aggregate expenditures.

Question 8

3.08 - So an upshift in saving would have what affect in the case of the paradox of thrift?

Answer 8

It would cause a multiple decline in the equilibrium GDP.

Question 9

3.09 - How can savings be beneficial given the paradox of thrift?

Answer 9

The savings must be matched by an injection (especially investment).

Question 10

3.10 - What is the recessionary gap?

Answer 10

It is the amount by which aggregate expenditures fall short of that required to generate the full-employment level of GDP.

Question 11

3.11 - What does a deficiency of aggregate expenditure produce?

Answer 11

This deficiency of aggregate expenditure produces a contractionary or depressing impact on the economy (ie. a multiple decline in real GDP).

Question 12

3.12 - What is the inflationary gap?

Answer 12

It is the amount by which aggregate spending exceeds that required to achieve the full-employment level of GDP.

Question 13

3.13 - An excess of aggregate expenditures produces what? and will cause?

Answer 13

An inflationary impact on the economy (ie. a multiple increase in nominal GDP). This will cause demand-pull inflation.

Question 14

3.14 - What is discretionary fiscal policy?

Answer 14

It is the deliberate manipulation of taxes (T) and spending by government (G) for the purpose of altering real GDP and employment controlling inflation and stimulating economic growth.

Question 15

3.15 - How are taxes and government spending categorised?

Answer 15

Taxes are leakages and government spending is an injection.

Question 16

3.16 - How does government spending affect the equilibrium GDP?

Answer 16

• Increases in G expand it

* Decreases in G contract it

Question 17

3.17 - How does government taxes affect the equilibrium GDP?

Answer 17

• Increases in T reduce it

* Decreases in T increase it.

Question 18

3.18 - In a three sector economy what is the equation for AE (and Real GDP)? And where does GDP equilibrium occur?

Answer 18

AE = C + I + G = Real GDP

GDP Equilibrium will occur where savings (S) = I + G

Question 19

3.19 - What is appropriate fiscal policy for unemployment?

Answer 19

Increases in government expenditure and decreases in taxes to create a budget deficit

Question 20

3.20 - What is appropriate fiscal policy to correct demand-pull inflation

Answer 20

Decreases in government expenditure and increases in taxes to create a budget surplus.

Question 21

3.21 - What is the definition of lump-sum tax?

Answer 21

A tax that collects the same amount of tax revenue, the lump sum, at each level of GDP.

Question 22

3.22 - What is the impact of taxes?

Answer 22

Tax reduce levels of both saving and consumption. How much S and C are affected depend on the MPC and the MPS

Question 23

3.23 - Using the leakages - injections approach, how is tax applied and where is equilibrium GDP located?

Answer 23

Taxes are also leakages, so are added to Sa, so it becomes Sa + T and equilibrium GDP is at the intersection of Sa + T and I+G.

Question 24

3.24 - What is expansionary fiscal policy?

Answer 24

Discretionary budgetary policy that increases government spending, lowers taxes, or combines these actions to assist the economy to recover from recession or depression. This will move the budget towards a deficit in recessionary times.

Question 25

3.25 - What is contractionary fiscal policy?

Answer 25

Discretionary budgetary policy that decreases government spending, increases taxes or combines these actions to reduce or eliminate inflationary pressures in the economy. This will move the budget towards a surplus in inflationary times.

Question 26

3.26 - The introduction of marginal taxes reduces the size of the multiplier by providing another income-sensitive leakage from the expenditures flow in the economy. Explain the equation T = TLS + MPT(Y) and what the mutliplier formula becomes?

Answer 26

Taxes = Lump sum tax + (the Marginal Propensity to tax X real GDP). So the mutliplier becomes 1 divided by MPT + MPS (1 - MPT)

Question 27

3.27 - What is the balanced budget multiplier?

Answer 27

The multiplier showing the amount by which equilibrium output is increased following the use of a discretionary fiscal policy that neither decreases the budget deficit nor increases it (because of equal increases in both government spending and taxes).

Question 28

3.28 - What does the balanced budget multiplier reflect?

Answer 28

The fact that consumption and saving are based on after tax incomes. Thus a shift in income from the private sector to government only reduces consumption spending by the MPC times the fall in disposable income - not by the total amount by which income is reduced.

Question 29

3.29 - How are equal increases in Government Spending and Taxes considered from a fiscal policy perspective?

Answer 29

They are considered as expansionary, though it is noted that tax increases may impact on productivity and incentive to work which could reduce the expansionary impact.

Question 30

3.30 - In an open economy, what is the Aggregate Expenditure equation?

Answer 30

AE = C + I + G + NX

Question 31

3.31 - What is the equation for NX and what does it mean?

Answer 31

Net Exports (NX) = Exports (X) (which are an injection) - Imports (M) (which are a leakage)

Question 32

3.32 - What is the volume of Australian Exports dependent on?

Answer 32

The level of incomes in foreign nations. High foreign incomes = higher Australian Exports, where as lower foreign incomes = lower Australian Exports.

Question 33

3.33 - What is the volume of Australian Imports dependent on?

Answer 33

Australian domestic income (DI). High DI = Higher imports, and lower DI = lower imports.

Question 34

3.34 - What other factors must be considered in determining imports and exports?

Answer 34

• Comparative costs and terms of trade
• Exchange rates
• Trade barriers

Question 35

3.35 - Explain how X and M are considered in terms of their dependency?

Answer 35

X is independent (based on foreign income) and M is dependant because it is based on DI or GDP. A rise in NX increases equilibrium GDP. Because NX = X-M, a rise in imports due to a rise in income results in a fall in NX.

Question 36

3.36 - What is the open economy multiplier?

Answer 36

It is 1 divided by the MPS + MPM and is the fraction of any change in national income that is spent on imports. So if the MPM is 0.1 and the MPS is 0.25, they are both leakages, so are added together. In this case 1 divided by 0.35 is 2.86.

Question 37

3.37 - What is the complex multiplier?

Answer 37

It is the multiplier that arises when all the leakages: savings, taxes and imports are taken into account and is represented by K. So K = 1/(MPT+MPS(1-MPT) + MPM), ie 1/leakages.

Question 38

3.38 - What are the key components of federal expenditure?

Answer 38

• Social security & welfare
• health
• education
• economic services
• defence

Question 39

3.39 - Federal revenue comes primarily from what three sources?

Answer 39

• personal income tax
• company income tax
• indirect and other taxes (GST & excise taxes)

Question 40

3.40 - Explain progressive tax rates and regressive tax rates and give an example of each?

Answer 40

• Progressive - That marginal and average tax rates increase as income rises. Personal income tax
• Regressive - applied to specific goods regardless of income level. GST & excises taxes

Question 41

3.41 - What is GST?

Answer 41

Goods and Service Tax is a form of value added tax where tax is added at each sale point in the production and distribution chain for the product.

Question 42

3.42 - What is excise tax?

Answer 42

A specific levy per physical unit usually placed on alcohol, tobacco and petrol.

Question 43

3.43 - What is discretionary fiscal policy?

Answer 43

It is the deliberate manipulation of taxes and spending by government for the purpose of altering real GDP and employment, controlling inflation and stimulating economic growth.

Question 44

3.44 - Is all fiscal policy deliberate?

Answer 44

No, because our tax and expenditure systems embed a certain amount of automatic stability into our economy.

Question 45

3.45 - What is expansionary fiscal policy?

Answer 45

It is the use of increased government spending and/or lower taxes to increase the government budget deficit in order to stimulate economic activity and move the economy out of a recession or depression. These actions expand the equilibrium level of GDP.

Question 46

3.46 - What is contractionary fiscal policy?

Answer 46

This is the use of reductions in government spending and/or higher taxes, thereby reducing the deficit (or increasing the surplus) in the governments budget to control demand-pull inflation. These actions contract (reduce) the level of GDP.

Question 47

3.47 - What would be appropriate fiscal policy to correct for unemployment?

Answer 47

Expansionary fiscal policy - because it requires increases in government spending and decreases in taxes

Question 48

3.48 - What are the two main ways for the federal government to finance a deficit?

Answer 48

1) Borrowing - ie selling interest bearing bonds to the public
2) Money Creation - in this case the deficit is financed by the RBA by issuing new money

Question 49

3.49 - What is the potential problem with the government ‘borrowing’ to finance a deficit?

Answer 49

By borrowing the government is competing with private business borrowers for funds and this may drive the equilibrium interest rate upwards, so may ‘crowd out’ some private investment spending. Money creation avoids this problem.

Question 50

3.50 - The effect of a contractionary fiscal policy depends on the method by which the surplus is financed. What are the two options?

Answer 50

• Debt reduction - may reduce the anti-inflationary impact of policy by reducing interest rates, thereby stimulating private spending, or
• Idle surplus - the government withholds purchasing power, in this case interest rates are unaffected.

Question 51

3.51 - What are the different positions taken by economists. Explain the view by liberal economists and conservative economists?

Answer 51

Liberal economists recommend expanded spending in recessions and constrained spending during inflationary periods by increasing taxes. Conservative economists recommend reducing taxes in recessions and reducing government expenditure.

Question 52

3.52 - What does non-discretionary fiscal policy refer to?

Answer 52

To the automatic adjustments that occur to the government’s fiscal balance over the business cycle. Non-discretionary fiscal policy reflects the built-in stabilisers present in our mixed economic system.

Question 53

3.53 - How do the built-in stabilisers act during a recession and during inflationary periods?

Answer 53

During a recession these stabilisers tend to increase the government deficit and reduce surplus.

During inflationary periods these stabilisers tend to increase the government surplus and reduce deficit.

Built in stability softens, but does not correct undesired change in the GDP.

Question 54

3.54 - Why do built-in stabilisers exist?

Answer 54

Because of the fact that net tax revenues vary directly with the level of GDP. Thus the presence of income-sensitive company tax, income tax and to a lesser extent the GST have a stabilising effect on output.

Question 55

3.55 - When is built in stability desirable in the economy?

Answer 55

When the economy is fluctuating around the full employment level of GDP. If it is in a recession the same degree of built in stability can make it more difficult to move to full employment.

Question 56

3.56 - What is fiscal drag and when does it occur?

Answer 56

It occurs where an economy stabilises at an undesirable output level because of the operation of automatic stabilisers. Over time as an economy grows this can choke off growth.

Question 57

3.57 - What is the cure to fiscal drag?

Answer 57

Discretionary fiscal policy.

Question 58

3.58 - What is a cyclically adjusted budget?

Answer 58

A cyclically adjusted budget indicates what the budget deficit/surplus would be if the economy were to operate at potential output throughout the year.

Question 59

3.59 - Why is a cyclically adjusted budget important?

Answer 59

Because:

• a government’s fiscal stance is difficult to judge,
• actual budget surpluses or deficits do not necessarily indicate the government’s true fiscal stance
• this is because built in stability alters the fiscal position.

Question 60

3.60 - What are the three main problems with fiscal policy in practice?

Answer 60

• Problems of timing
• Political problems, and
• the Crowding out effect

Question 61

3.61 - What are the ‘problems of timing’ with fiscal policy in practice?

Answer 61

1. recognition lag - time lapsed between beginning a recession/inflationary period and recognising it
2. administrative lag - time lapsed between recognition and decision to act
3. operational lag - time lapsed between fiscal act and when the act has an impact on output, employment and price levels.

Question 62

3.62 - What are the ‘political problems’ with fiscal policy in practice?

Answer 62

1. other economic goals - government is concerned with more than just stability
2. expansionary bias - deficits are popular and surpluses are not
3. a political business cycle - the view that fiscal policy is manipulated by politicians to maximise voter support

Question 63

3.63 - What is the ‘crowding out effect’ with regard to fiscal policy?

Answer 63

This occurs where an expansionary fiscal policy is in place. Interest rates increase, thus reducing interest sensitive private spending, especially investment, thereby weakening or cancelling the stimulatory effects of fiscal policy.

Question 64

3.64 - What is a budget deficit?

Answer 64

It is the amount by which the government’s expenditures exceed its revenues during a particular year.

Question 65

3.65 - What is the public debt?

Answer 65

Public debt is the total accumulation of the federal government’s total deficits and surpluses that have occurred over time (national debt).

Question 66

3.66 - What are the three different types of budget philosophies?

Answer 66

1. Annually balanced budget
2. Cyclically balanced budget
3. Functional finance

Question 67

3.67 - What does the ‘annually balanced budget’ philosophy suggest?

Answer 67

It suggests the budget should achieve a balance in each year. This is pro-cyclical so intensifies the business cycle (recession or inflation)

Question 68

3.68 - What does the ‘cyclically balanced budget’ philosophy suggest?

Answer 68

It suggests the budget should achieve balance over the business cycle. This is counter-cyclical because taxes are lowered and spending increased in a depression and taxes increased and spending decreased in an inflationary period.

Question 69

3.69 - What is the problem with a cyclically balanced budget?

Answer 69

That upswings and downswings may not be of equal magnitude and thus stabilisation conflicts with balancing the budget over the cycle, eg a long recession followed by a short period of prosperity would result in a large deficit.

Question 70

3.70 - What does the ‘functional finance’ budget philosophy suggest?

Answer 70

The primary purpose is to balance the economy not the budget. The problems of continuing annual deficits (or surpluses) may be small compared to the alternative: recession and high unemployment OR inflation/hyperinflation

Question 71

3.71 - What are the key indicators as to whether the government of a country can pay its interest bill on its public debt?

Answer 71

• share of government expenditure allocated to debt payments

* ratio of the interest liability on the debt to GDP.

Question 72

3.72 - What are the two myths of Australian public debt and why are they not true?

Answer 72

1) the Government is going bankrupt
2) We are shifting the burden to future generations

These are not true because the government can refinance existing debt; AND the government can create more money.

Question 73

3.73 - What are the two key problems with public debt?

Answer 73

1) Economic implications

2) Crowding out and the stock of capital

Question 74

3.74 - What are the economic implication problems with public debt?

Answer 74

1) External debt may be a problem
2) increased taxes may dampen incentives to bare risk, to innovate, to invest and to work
3) income distribution - bonds are generally owned by the wealthy, so payment of interest on the debt may contribute to income inequality
4) composition is important - capital verses consumer goods

Question 75

3.75 - What is meant by ‘crowding out and the stock of capital’ when referring to the public debt?

Answer 75

That future generations inherit a smaller stock of capital goods due to the crowding out effect, which increases interest rates and so reduces investment spending.

Question 76

3.76 - What are two important qualifications that may reduce or even eliminate the size of the economic burden shifted to future generations?

Answer 76

1) Public investment - if government spending is on consumption type outlays then the shifting burden is correct, however if it is investment outlays, it is increasing public capital.
2) Unemployment - if unemployment exists initially, deficit spending by government need not entail a burden for future generations.

Question 77

3.77 - What is the positive role of public debt?

Answer 77

That debt creation transfers saving to spenders and thereby may play a positive function in maintaining a high level of output and employment.