Question

Question 2: Fiscal Policy

Suppose the economy is in a recessionary gap, and the government reponds by conducting an

expansionary fiscal policy.

a. Suppose the marginal propensity to consume is 0.8. Calculate the effect of a $1,000

increase in government purchases on real GDP, and then calculate the effect of a $1,000

tax cut on real GDP.

b. Why does a $1,000 tax cut generate a smaller multiplier effect than a $1,000 increase in

government purchases?

Answer 1

Marginal propensity to consume = b = 0.8

Part a)

We know that;

Government expenditure multiplier = 1/(1-b)

That is;

dY/dG = 1/(1-b)

dY = dG/(1-b)

They have given increase in G = dG = $1,000

Hence;

Increase in real GDP = dY = 1,000/(1-0.8) = $5,000

Increase in real GDP = dY = $5,000

Similarly, we know that;

Government Tax multiplier = -b/(1-b)

dY/dT = -b/(1-b) = - 0.8/(1-0.8) = -0.8/0.2 = -4

dY/dT = -4

Now, it is given that tax is cut by $1,000; that is dT = -$1,000

Hence;

Increase in real GDP = dY = -4dT = -4*-1,000 = $4,000

Increase in real GDP = dY = $4,000

Part b)

A $1,000 tax cut generates a smaller multiplier effect than a $1,000 increase in government purchases.

This is because the entire government spending increase goes towards increasing aggregate GDP, but only a portion of the increased disposable income (C = Y - T; resulting for lower taxes) is consumed.