Apr 17 2009
The potency of government spending and taxation.
Published by Andrew McCarthy at 5:50 pm under
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WikipediaEconomic View – A Dose of Skepticism on Government Spending – NYTimes.com
We all understand that fiscal stimulus is one of the tools that governments can use to increase the level of economic activity during a recession. The fiscal medicine can be delivered in one of two ways. The government can tweak the tax systems to boost incentives to spend and work or it can increase government spending. One tool that we can use to evaluate the merits of these two policies is to compare the relative multipliers that relate to government spending and taxation.
The multiplier is the key component of Keynesian theory and shows the possibility of a given increase in injections, e.g. government spending, investment and exports, increasing aggregate demand by more than the initial value. This logic fits with our understanding of the circular flow where say increased government spending will lead to increased derived demand for other products, and increased demand for labour. Workers will spend additional wages on other products which leads to further increases in aggregate demand. This flow on effect can be diluted by withdrawals from the system such as taxation or savings.
Greg Mankiw wrote an excellent analysis of this issue in the New York Times in Janurary. “A dose of skepticism on government spending”
An essential skill for IB and AP Economics students is to be able to evaluate the effectiveness of Keynesian demand-side policies as well as classical supply-side policies, both fiscal and monetary. An understanding of multipliers can improve a student’s ability to evaluate fiscal policy. Greg writes:
“Economics textbooks, including Mr. Samuelson’s and my own more recent contribution, teach that each dollar of government spending can increase the nation’s gross domestic product by more than a dollar. When higher government spending increases G.D.P., consumers respond to the extra income they earn by spending more themselves. Higher consumer spending expands aggregate demand further, raising the G.D.P. yet again. And so on. This positive feedback loop is called the multiplier effect.
In practice, however, the multiplier for government spending is not very large. The best evidence comes from a recent study by Valerie A. Ramey, an economist at the University of California, San Diego. Based on the United States’ historical record, Professor Ramey estimates that each dollar of government spending increases the G.D.P. by only 1.4 dollars. So, by doing the math, we find that when the G.D.P. expands, less than a third of the increase takes the form of private consumption and investment.”
This low multiplier effect implies that any government spending must be used in an effective manner where it will increase the long-term productivity of the country. During a “jobs think-tank” recently in New Zealand, a media release announced an idea of the government spending a vast sum of money to develop a walking track from one end of the country to the other. Would this lead to increased tourism? How much money would these hiking visitors spend? Would it create more jobs?
Should we therefore expect that tax cuts will lead to a greater increase in GDP through the feedback loop compared to government spending? Well, we have to remember that not all tax cuts will be spent immediately, according to the marginal propensity to consume. In a recession some workers will be pessimistic about the future and save the money. Will tax cuts compensate workers who are working shorter hours? Greg suggests that tax cuts might actually be more potent than government spending according to current research.
“Textbook Keynesian theory says that tax cuts are less potent than spending increases for stimulating an economy. When the government spends a dollar, the dollar is spent. When the government gives a household a dollar back in taxes, the dollar might be saved, which does not add to aggregate demand.
The evidence, however, is hard to square with the theory. A recent study by Christina D. Romer and David H. Romer, then economists at the University of California, Berkeley, finds that a dollar of tax cuts raises the G.D.P. by about $3. According to the Romers, the multiplier for tax cuts is more than twice what Professor Ramey finds for spending increases.
Why this is so remains a puzzle. One can easily conjecture about what the textbook theory leaves out, but it will take more research to sort things out. And whether these results based on historical data apply to our current extraordinary circumstances is open to debate.”
So the current research indicates that one-dollar of tax cuts can increase G.D.P by $3 compared to an additional dollar of government spending increasing GDP by $1.40. But why is there such a large difference? Is this related to the arguments about the efficiency of increased government spending? The verdict is still out and we may need to wait till the next global recession to find out.
Below is a picture of the aptly named Bridge to Nowhere located in the central North Island of New Zealand. It was built by the government in a spending splurge in the 1936 to open up land in the area. The land is now no longer fertile or accessible and all access to the area is cut off except for this concrete relic. The area is now popular with trampers.
Discussion Questions:
- How do economists calculate the multiplier?
- What are leakages from the circular flow that reduce the multiplier effect?
- Explain the link between the accelerator model and the multiplier.
- What would multipliers for other injections such as export receipts or investment look like? Would they be higher or lower than multipliers for taxation or government spending?
- Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity.
About the author: Andrew teaches IB Economics and IB Business Management at the International School of Singapore. He has previously taught in Wellington, New Zealand and graduated from Victoria University of Wellington. Related posts:
- How big is the government spending multiplier in America? Well, it depends on which economist you ask…
- The Multiplier Effect as it applies to the Obama camp’s fiscal stimulus proposal
- A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out
- Supply – side economists: “lower taxes, more growth, more tax revenue!”
- Growing pains
Teachers!
Submit your Econ questions here. Replies will be posted to the blog
How do economists calculate the multiplier?
When injections are increased (investments, exports or government spending), the aggregate demand is therefore increased which will increase a firms output. When more output is produced, more income will be distributed to households by firms. Households will then have more money to spend on goods and services, which will additionally increase aggregate demand.
What are leakages from the circular flow that reduce the multiplier effect?
Leakages are factors that prevent the income that households earn not being spent again. Savings, taxes and imports are factors that decrease the expenditure on goods and services. If these leakages are higher than the injections, the national output falls.
Explain the link between the accelerator model and the multiplier:
The accelerator model is a matter to the multiplier effect! The accelerator model increases the national output even more. First like explained before by the multiplier effect, injections increase consumers income, which will lead to their rise of aggregate demand and therefore which will boost the national output. Additionally through the acceleration process firms will invest to keep up with this rising demand of consumers and therefore, since investments are part of injections start the process of the multiplier effect again, which will more and more increase national income.
What would multipliers for other injections such as export receipts or investment look like? Would they be higher or lower than multipliers for taxation or government spending?
The multiplier effect for leakages (taxes, imports) will be less than for injections (investment, exports), since the government will cut taxes to increase consumer spending.
Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity
Increasing disposable income would only lead to a greater consumption when the injections are higher than the leakages. Only then the fiscal stimulus was successful. Additionally, corporate taxes can be increased to enjoy higher tax profits. Also investment projects from governments themselves can surely increase the demand curve and could also make this policy successful.
Still it is hard to estimate how much spending a government has to do to insert the right stimulus. A stimulus will only be effective if the government dept can be resolved afterwards.
1. You can calculate the multiplier two different ways: The first one is 1/ MRL, where MRL is the marginal rate of leakage and the second one is 1/(1-MPC), where MPC is the marginal propensity to consume.
2. Leakages from the circular flow are peoples’ savings and imports. Savings result in income money which is not spent further in the economy and the purchase of imports are not counted towards the country’s GDP which doesn’t cause it to change.
5. The idea of fiscal policy is to stimulate the economy in bad times. A nation’s aggregate demand which measures the total spending on goods and services in a period of time at a given price level and can also be seen as its real total output which is made up of 4 components: Investment, Consumption, Government Spending and net Exports. In a recession, household’s consumption, the investments made by firms and net exports are decreasing. Therefore, the government decides to increase government spending known as fiscal stimulus to balance out the effect of a decrease of the other 3 components on the nation’s GDP.
Economists calculate the multiplier effect two different ways. Once is dividing 1/1-MPC and the other is 1/MRL. The MPC is the Marginal Propensity to Consume, which is the proportion of any change in income used to consume domestically produced output. This can be obtained by dividing the Change in Consumption over the Change in Income. The other way of obtaining the multiplier is by obtaining the rate of leakage, which is the proportion of any change in income saved, used to pay off debts, or to purchase imports. Once the MRL is found then the multiplier effect can be obtained by 1/MRL.
Leakages that leave the circular flow are savings and imports. Savings are leakages because it is income money that is not spent in the economy. The purchase of imports is a leakage because the money used for that purchase does not go towards the circular flow of that country, it goes to the country that exported that good.
Fiscal stimulus can be very effective if implemented properly A fiscal stimulus is basically an injection of money from the government into the economy. This is a form of government spending. The goal is to increase consumption, which would then increase investment and would finally increase GDP. This method can only be successful if implemented properly. If too little money is spent by the government then consumption will not increase that much. If too much is spent then the opposite will happen. A fiscal stimulus does not necessarily mean that people will consume more because of the fact that they have more money. If they are not confident enough then they will not consume the money, they will save it for the future.
The multiplier is calculated by 1/MRL, the marginal rate of leakage. MRL is equal to 1-MPC, the marginal propensity to consume. The marginal propensity to consume is the change in consumption/ the change in income.
Leakages from the circular flow that reduce the multiplier effect are savings, imports and taxes. Imports are counted on another countries GDP, savings are not brought back into the circular flow and taxes are kept by the government.
Fiscal policies increase aggregate demand by lowering taxes or the government itself increases their spending. By lowering taxes the people have more disposable income to spend on other things and therefore consumption in an economy increases. Governments can also spend money so that more jobs are available which also increases consumption and as a result changes aggregate demand.
1. The multiplier is calculated by an estimate of how increased injections will effect consumers and households. If there are more government injections into the economy people will feel more confident in consuming and the aggregate demand will increase, which will increase companies output. Once output increases households will feel “richer” and feel more confident and spend more money, which will increase aggregate demand even more.
2. Leakages from the circular flow are when households save the money instead of spending it one goods. This will reduce the multiplier effect because the money will be there but if now one spends it, then aggregate demand will not increase.
3. Fiscal policy model can be very effective during a recession. It is like a big injection into the economy by the government, where they also reduce taxes, which will make households and consumers feel richer. Once people start feeling like they have enough money to go spend, they will start consuming again which would “jump start” the economy. More money will start circulating the economy and households will feel more confident to start spend money again. GDP and aggregate demand will increase and the economy will start restoring itself. The multiplier has a similar effect on the economy because it gives households confidence to start spend money again.
What Theresa is trying to say above, in reference to the first question is: when the government puts money into the economy, it results in more growth in gdp then the amount they put in due to the multiplyer. Yet the quesiton is clearly how this effect works. (I’m not being mean Theresa, you really need to know this for the test coming up) The multiplyer effect depends on the marginal propensity to consume. Otherwise known as the proportoin of income spent on consumption by households. Governments gather statistics about what proportion of the money is saved (Marginal rate of leakage) and by deviding 1 by that proportion they calculate the multiplier. I agree with Theresa that some factors of leakages are savings, imports and taxatoin, yet she did not mention the repayment of debts which is also important. The accelerator model is caused by the multiplier effect, allowing the gdp growth to accelerate due to the injection of government spending. Injections into investment and export receipts would look like reductions in intrest rates and duty tax rates. Theresa concluded that the multiplier would be lower for tax cuts then for govermnent spending. Yet though her answer is accurate to Keynsian theory, in reality, the figure shows tax cuts having almost three times as much of a multiplier effect as direct government spending, so I will agree with the data. Fiscal stimulus is vital, since though it is ineffitient, and the economy would correct itself eventually anyway, it creates a structure in which our economies will stabalize and grow. We do not have time to wait for the alternative to work, nor the brutality to abolish minimum wage laws to let the economy self correct. The stimulus package is the only option left to governments, and its a good investment, since if for every dollar they spend they increase GDP by 3 dollars, that means there are now two dollars which have been created, and which will build on themselves for years to come. Over time the government should be able to repay much of the debt.
The multiplier is calculated using the Marginal Propensity to Consume (which is the change in income divided by the change in consumption) in the following equation: 1/ (1-MPC).
Marginal Rate of Leakage is the money that isn’t used in consumption, but instead is lost as a result of saving, spending on imports, paying off debts. It can also be used to calculate the multiplier effect (1/MRL). Evidentally, MRL + MPC = 1
Fiscal stimulus is important during a recession to help stimulate economic activity, primarily consumption and investment. However the main factor that assures a successful multiplier effect is the confidence in the consumers who have the choice of either spending most of their income, or saving it. The fiscal stimulus might especially not be as successful during a recession, during which people’s confidences in the economy are so low that they tend to save more than spend.
1) To calculate the multiplier effect you have to understand the marginal propensity to consume and the marginal rate of leakage. The marginal propensity to consume is the portion of a change in income spent on domestically produced output. It is calculated by the change in consumption divided by a change in income. The marginal rate of leakage is the opposite, it is the portion of this change in income saved. In total both of them added equal 1. The spending multiplier is calculated by 1 divided by MRL. This is the amount that the nation results with after the government spending takes place.
2) Leakages include people saving their money and purchasing imports (since these are not goods that have been produced within the country which means they are not part of the real output, or GDP.)
5) Fiscal stimulus is effective depending on the society. If it is a society that are more prone to spend rather than save when there is an income raise, then a fiscal stimulus will be very effective. According to this article, it depends how much of this fiscal stimulus is government spending and how much is tax cuts. Supposedly, tax cuts increase the GDP by a greater amount than government spending. However people can save up on the money they do not spend on taxes, while the money the government spends is spent, so this theory contradicts these studies.
1. How do economists calculate the multiplier?
The multiplier can be calculated by dividing 1 by MRL (MRL = Marginal Rate of Leakage). Another way of finding the multiplier is by dividing 1 by 1-MPC (MPC = Marginal Propensity to Consume).
2. What are leakages from the circular flow that reduce the multiplier effect?
The leakages in the circular flow are saving your money and buying foreign goods, imports. This is so because the money you are receiving could be used to purchase goods and help the economy grow, stashing this money in fact slows the economy down. Purchasing imports is a leakage because the money you are paying for that specific good does not go to the nation’s income, but rather to another one’s.
5. Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity.
A fiscal stimulus is what the USA is fueling its economy with at the moment. This is theoretically very useful because this goes under G, government spending, and hence increases aggregate demand with it. By increasing aggregate demand, consumption as well as investment. This however does not always achieve this result, as in the USA right now. People do not feel confident enough to spend their money and therefore prefer to stash it. Overall, the entire economy is dependant on confidence, if the people do not feel confident enough to purchase goods and servcies, then economy will slow down as their spendings slow down.
1. Calculating the multiplier: 1/ MRL, where MRL is the marginal rate of leakage
2. Leakages from the circular flow are savings as well as imports. Savings is income that is not spent and therefore not put in the circular flow. Imports add to the GDP of the country where the product was bought from but not to the domestic GDP.
5. When households consumption, firms investment and net exports are too little, the big G, the government tries to boost GDP with a fiscal injection. This might help the GDP to increase for a while, but besides GDP, the government also increases its debt. That is what the Obama administration is doing at the moment. In the long-run the Government might have to increase taxes or do other unpleasant things to achieve the money that they need to pay back.
The multiplier is calculated using the following equation: 1/(1-MPC), where MPC equals the marginal propensity to consume. The marginal propensity to consume can be described as the change in consumption divided by the change in income.
The leakages from the circular flow that reduce the multiplier effect are the money that is kept as savings, as well as imports (which are counted in another country’s GDP) and money that is used to pay off previous debts or mortgages.
A fiscal stimulus is very important during a recession because it will stimulate households to consume more and firms to invest. However, a big part of a recovery is confidence. Even if a government increases spending during a recession, they expect a certain amount of confidence to be restored. If it does not occur, the stimulus will have no effect on the economy and more money will be saved rather than spent.
Economists calculate the multiplier with the following formula
m=1/(1-MPC)
The circular flow leakages are savings, taxes and imports
It is impossible to tell whether the multiplier effect would be greater for investment, exports or government spending. It depends on the amounts involved and the reaction of the consumers, firms and everyone else in terms of confidence.
Fiscal policy seems to be an effective way to increase a nations GDP. Although returns might not be huge, 1.5-3%, they are also low risk.
1) The multiplier is 1/MRL marginal rate of leakage ( the proportion of income that is not used for spending) This multiplier basically tells how much the government has to spend on its fiscal policy.
2) MRL includes savings, taxes, imports, depts.
3) The multiplier effect makes induced investment accelerate. For instance a firm will have the incentive to increase its capacity by investing in new plants so that they can deal with an increase in demand due to a fiscal policy.
There are 2 ways to calculate the multiplier effect one is, 1/MRL where mrl is the marginal rate of leakage. And the other way is 1/1-MPC where MPC is the Marginal Prosperity to Consume.
The leakages in the circular flow can normally be due to 2 things, Saving and buying imports. When people save, they take the money out of system, and this decreases the multiplier effect because if for example the Government gives everyone $100 to help boost the economy and if every saves $80 then there will only be $20 dollars will be put into circulation. The other leakage is through buying imports, if you buy imports you no longer are boosting your own economy but that of another therefore their is a leakage.
When the governments and firms increase their investments and government spending, the Ad increases and allows firms to maximize their output. Since more is being produced, more will be consumed which means there is more money flowing around. All the money that is spent goes to household as income. Now that everyone’s income has increased the Real GDP will go up, household will be able to by more goods or services and therefore aggregate demand will increase more as well.
1. Economist calculate the multiplier by finding the proportion of income not used on spending, 1/MRL. This number indicates to governments how much must be spent on fiscal policy.
2. Leakages from the circular flow that reduce the multiplier effect include savings, taxes, and imports.
3) The accelerator model is directly affected by the multiplier, people and firms will have more incentive to spend causing the multiplier to change if the governments pump money into the economy.
1.) Economists calculate the multiplier in two different manners. 1/ MRL, where MRL is the marginal rate of leakage and the second one is 1/(1-MPC), where MPC is the marginal propensity to consume give us the multiplier.
2.) Savings and foreign imports are leakages from the circular flow diagram. Savings is the income people do not inject into the economy again. The purchase of foreign imports counts to the foreign country’s GDP, not the country where it is being bought.
5.) Fiscal stimulus is very effective in increasing or keeping GDP up. Currently the US is doing this, and it is keeping the GDP from falling, but it is also increasing the countries debt. Obviously the hope is that the multiplier effect will increase the GDP more than how much is injected.
1. We calculate the multiplier using either 1/MRL where; MRL = marginal rate of leakage, or 1/(1-MPC) where; MPC is the marginal propensity to consume.
2. Leakages from the circular flow are savings and foreign imports. Savings are money that never gets into the economy, and imports give benefits, in terms of GDP, for the exporter not the importer.
5. The effects of fiscal stimulus depend entirely upon the people of that country. Because they reply on the multiplier effect, if people don’t spend the extra cash the fiscal policy is giving them, but rather save them then the effects will not be felt. If the people of the nation do as is intended with the fiscal policy then they will be very effective.
The equation for the multiplier is 1/marginal rate of leakage (MRL) and MRL, in turn, = 1- marginal propensity to consume (MPC) which is the chang ein either income or consumption in an economy.
Savings (are kept by the consumers) , taxes (are collected and kept by government), imports (go to the other countries GDP) and exports are all leakages from the circular flow which causes a reduction in the multiplier effect.
The government can increase it’s spending which will increase confidence and should then increase consumption and investments again. Taxes can also be lowered in order to give a more disposable income to people who will thn invest or consume more.