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
- Supply – side economists: “lower taxes, more growth, more tax revenue!”
- A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out
- The Costs of the Bailout, More Government Debt
Do you like what you read on this blog? The author is currently working on an Economics textbook that will be available to order in Spring 2011. For more information, click above.
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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.
1. How do economists calculate the multiplier?
They use an analysis of the percent increase in real GDP when government money is injected into the economy. They use a ratio form in order to determine how much each dollar spent increases the GDP.
2. What are leakages from the circular flow that reduce the multiplier effect?
The main leakage from the multiplier effect is the marginal propensity to save. When consumers receive a dollar, they won’t spend all of it. They’ll save some of it. Another leakage is money that’s spent on imports. These will reduce the effect that something such as tax cuts will have on the economy.
3. Explain the link between the accelerator model and the multiplier.
While government spending and tax cuts undergo the multiplier effect which encourages consumers to spend, the accelerator model explains how an increase in GDP will encourage firms to invest more. Both are additions to the initial injections into the economy.
4. 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?
They would probably be fairly similar. I would guess, though, that they would be smaller. Government actions seem to me to be the most effective policies that can change the level of GDP.
5. Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity.
I think to a certain extent, fiscal stimulus can increase the level of economic activity. Government spending and tax cuts will undoubtedly push aggregate demand to the right and are useful tools for during a recession. At the same time, though, we cannot rely completely on government fiscal stimulus. Getting consumers to spend and firms to invest is the most important thing. Without this, no economic recovery can occur and inflation cannot be successfully combated.
Trevor Tezel
1. The multiplier is calculated using the formula 1/MRL, where MRL is the marginal rate of leakage. MRL is equivalent to 1 minus MPC, where MPC is the marginal propensity to consume. The marginal propensity to consume is the change in consumption divided by the change in income.
2. The leakages from the circular flow that reduce the multiplier effect are factors that prevent the income that households earn from being spent again within an economy. These tend to be taxes, imports and savings. If leakages are greater than injections into an economy, the result will be a fall in national output.
3. The relationship between the multiplier and the accelerator is that they are both additions to the original injections into an economy. The multiplier compounds the effect that an initial amount of government spending or cuts in taxes has on consumer spending, and the accelerator is the extent to which a boost in GDP resulting from government spending can encourage firms to invest.
4. It would really depend on the composition of the economy. For example, if it was a mainly export based economy, then probably the multiplier would be larger than if the country produced most of its goods and services.
On the whole, however, I think that multipliers for taxation and/or government spending would be higher than other injections, because taxation has an affect on every individual and organization, and only the government has the power and the resources to act on a very large scale to produce significant changes. Of course, this also depends on the level of government involvement in the economy.
5. I think that fiscal stimulus should be used with care and the timing should be well judged. It would be unwise to for the economy to be too reliant on stimulus from the government. Also, demand-side policies tend to be good for boosting an economy out of a recession, whereas supply side. I also think that, in the short run, fiscal stimulus can like tax cuts and subsidies can help the AD curve shift to the right. However, in the long run, I think that, given the scarce resources we face, long run aggregate supply is inelastic, so that demand will eventually revert back to equilibrium level, albeit at a higher price level.
–
Dear Trevor,
I agree with you that getting consumers to spend and firms to invest is important on getting an economy back on track during a recession. I think maybe why the government has such an important role during the recession is because recessions are fueled or made worse by a lack of confidence in the economy; no rational person or firm is willing to take the risk to invest or consume when they are unsure of economic conditions or the economic future. So I suppose that by using fiscal stimulus, the government is essentially underwriting an economy in the hope that this will give people greater confidence.
1. Economists calculate the multiplier by dividing the eventual change in GDP by the amount of the injection into the economy.
2. Some leakages from the circular flow that reduce the multiplier effect are saving, spending on imports, and taxation.
3. As the multiplier model shows disproportionate effects of government injection on changes in GDP and the accelerator model shows disproportionate effects of changes in GDP on investment, the two may be linked together to state that government injection disproportionately affects income.
4. Multipliers for export receipts and investment would exist, but they would be lower than multipliers for taxation or government spending because spending is based more on these direct changes to income than on other, smaller changes to the business cycle as a whole.
5. Fiscal stimulus can help to increase the level of economic activity. However, many people choose to save stimulus packages, especially in a time of recession. Therefore, direct government spending may be more effective in stimulating the economy.
Chamonix
Marc,
I liked how you noted that fiscal stimulus can cause national debt. I would say that this is also true for government spending. This makes understanding of the multiplier effect vital. If governments are going to either directly spend money or inject funds into the economy, they must be sure that the returns will be great. This makes stimulus packages very appealing, although individuals may save the money instead of spend. However, the multiplier effect is less assured on direct government spending, which may mean that the returns are not great enough to make government investment worthwhile. This helps to make the government much more aware of the urgency of these decisions.
Thanks,
Chamonix
1. How do economists calculate the multiplier?
Dividing the change in GDP by the amount of the injection into the economy.
2. What are leakages from the circular flow that reduce the multiplier effect?
They could be savings people usually have, or spending on imports.
3. Explain the link between the accelerator model and the multiplier.
Well, as government spending has a multiplier effect of increasing the GDP by more than what was spent, the increase in GDP increases investment by more than what the GDP grew. Thus government spending increases GDP and GDP increases investments.
4. 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?
They would be lower, since changes in GDP are derived from what people consume, which is more affected by changes in income than anything. Thus, as government measures affect much more people’s wages, they will have a greater multiplier effect than exports or investment.
5. Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity.
Fiscal stimulus is useful when going out of a recession, since they boost aggregate demand, but after economic growth has been achieved, they only create inflationary pressures.
Chamonix,
Well, I think we do not agree on the effects of fiscal stimulus, as we totally wrote the opposite. It’s true that people tend to save some of the stimulus packages in a recession, but the rest works to boost aggregate demand (in addition, I dont know how you could save government spending) Moreover, after leaving the recession, these policies would in fact be dangerous, since as I said, they create inflationary pressures, demand growing too fast compared to supply, a and dragging a recession threat again.
1.How do economists calculate the multiplier?
The multiplier is calculated by dividing the change in GDP by the amount of the injection into the economy.
2.What are leakages from the circular flow that reduce the multiplier effect?
Leakages are money that is not spent to increase the GDP. This includes saving and spending on imports.
3.Explain the link between the accelerator model and the multiplier.
The multiplier shows the disproportionate effect of government spending on GDP, and the accelerator shows the disproportionate effect of changes in GDP on investment. This means that through both effects, government spending can have a disproportionate effect on investment.
4.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?
They would be lower. Because government spending is a component of GDP on its own, as well as affecting consumer spending through incomes, it has a disproportionate effect on GDP. Investment and exports do not affect consumer spending as much, so the multiplier is smaller.
5.Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity.
Fiscal stimulus can increase government spending and consumer spending, both components of aggregate demand. However, the increase in consumer spending is dependent on the amount of leakages from the circular flow. If a lot of people save money they get from lower taxes rather than spending it, then the effect will be lessened.
Marcelo,
You mention the potential long-term threat of inflation, as maintaining fiscal stimulus during economic growth can cause aggregate demand to continue increasing even at the point of full employment. This is clear in the current worries among many governments about when to end stimulus. The general conclusion thus far is that is should be sustained until the recovery takes hold. After that, you are right in that this policy will be inflationary.
How do economists calculate the multiplier?
Economists calculate the multiplier by dividing the change in GDP by the change in injection. The general formula is (1/1) – MPC where MPC = Marginal Propensity to Consume which is equivalent to 1/MPS where MPS= Marginal Propensity to Save.
What are leakages from the circular flow that reduce the multiplier effect?
The leakages from the circular flow refer to the outflow of capital from the domestic economy. It can occur in the form of consumption on import goods or income saving.
Explain the link between the accelerator model and the multiplier.
Accelerator Theory refers to the fixed investment into the economy that would lead to proportionally larger change in the level of national income. Investment into certain industry increases the aggregate demand of machinery and labor necessary for the firms especially when the economy is near full employment and requires an expansion.
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?
I believe that multipliers for taxation or government spending would bring a larger effect into the economy because of its large-scale expenditure on various sector, whereas, the injection into export receipts or investment – smaller-scale injections – are concentrated to certain industry so the overall change at the level of national income would be small relative to government expenditure.
Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity.
Fiscal stimulus brings a fair amount of increase in the level of economic activity. Large-scale government expenditure and investment into specific sector would shift the aggregate demand curve to the right and increase the national’s output and demand. It is especially effective when the economy is under recession where unemployment are mainly caused by deficiency of demand.
@Marcelo
Haha. I agree that you can’t really save govenrment expenditure. I think what she meant was that people would tend to save their income (which comes indirectly from the government through multiplier effect), caused by the inflationary pressure due to increase in AD.
1.How do economists calculate the multiplier?
Dividing the change in GDP by the amount of the injection into the economy.
2.What are leakages from the circular flow that reduce the multiplier effect?
Money spent that doesn’t increase the GDP. If we consider the circular flow then this is money spent on imports and people saving money.
3.Explain the link between the accelerator model and the multiplier.
The multiplier is where government spending has a disproportionate effect on the GDP and an accelerator has the same effect yet the It is a fixed investment into the economy which reaps the reward of higher national income. They both increase the the GDP disproportionately.
4.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?
There is a much greater effect through the use of multipliers for taxation as this can be spread across all sectors within an economy and will cause that disproportionate rise in the GDP. If we only considered injections like export receipts than this will have a smaller scope than the taxation and therefore will have a smaller effect than government spending or taxation.
5.Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity.
Fiscal policies are usually used in times of economic depressions where we see that aggregate demand is very low. Now theses fiscal polices are very good at stimulating the market and increasing the demand so that the demand cure shifts right and we see an increase in the output and supply.
Hi Masaya,
Great well thought out answer that clearly defines and answers the questions in quite some detail. I definatley agree that fiscal policies are at there most effective when in a recession because we see large unemployment and low demmand these policies will lead the out of recession but if used to long can cause inflation.
Dan
Masya,
Your analysis seems spot on. Since there’s little room for opinion on these discussion topics I think it would be difficult to offer any criticism or discussion. You seem to understand the concept of the multiplier, accelerator, and fiscal stimulus. Looking at the rest of the posts, it seems like everyone has come to the same “evaluation.” Fiscal stimulus does help increase aggregate demand and will get an economy out of a recession.
- Trevor Tezel
1. How do economists calculate the multiplier?
Economists can calculate the multiplier with the formula 1/marginal rate of leakage. The marginal rate of leakage is 1-marginal propensity to consume. The final formula comes to 1/(1-mpc).
2. What are leakages from the circular flow that reduce the multiplier effect?
Leakages from the circular flow are savings and imports. Savings result in income that is not spent in the economy making it a leakage, as well as imports because the money used for imports does not go into the circular flow of the country meaning it does not affect the multiplier.
3. Explain the link between the accelerator model and the multiplier.
The link between the accelerator model and the multiplier is that they are both additions to the original injections into an economy. The multiplier adds the effect that an initial amount of government spending or cuts in taxes has on consumer spending while the accelerator model is how the increase of GDP resulting from government spending can encourage firms to invest.
4. 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?
They would probably be similar to the previous injections, but also probably smaller.
Government actions are the most effective policies that can change the level of GDP.
5. Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity.
Fiscal stimulus works very well when it comes to the increase of GDP. On the other hand, it also increases a country’s debt, but the hope is that the multiplier effect will increase the GDP to more than what was initially injected.
Daniel,
I like your answer to questions 4, you’re right, export receipts would have a smaller scope than taxation and would have a smaller effect than government spending. However, i think that government spending is sometimes more necessary as it can lead to better economic development
Sara
Economists calculate the multiplier by dividing the change in GDP by the amount of the injection into the economy.
Examples of leakages from the circular flow could be savings people accumulate, or spending on imports.
As government spending has a multiplier effect of increasing the GDP by more than what was spent, the increase in GDP increases investment by more than what the GDP grew. Thus government spending increases GDP and GDP increases investments.
Multipliers for other injections would be lower since GDP changes are derived from what people consume, which is affected more by changes in income than anything else. Thus, as government measures affect more people’s wages, they will have a greater multiplier effect than exports or investment.
Fiscal stimulus is useful when going out of a recession, since it boosts aggregate demand, but after economic growth has been achieved, it can only create inflationary pressures.
Sara,
You mention the potential long-term threat of inflation, which is a clear in the current worries among many governments about when to end stimulus. The general conclusion thus far is that it should be sustained until the recovery takes hold. After that, you are right in that this policy will be inflationary.
-Dennis-
Discussion Questions:
How do economists calculate the multiplier?
1/(1-MPC)
What are leakages from the circular flow that reduce the multiplier effect?
Savings, Import payments, Taxation
Explain the link between the accelerator model and the multiplier.
The link between the accelerator model and the multiplier is that they are both additions to the original injections into an economy. The multiplier adds the effect that an initial amount of government spending or cuts in taxes has on consumer spending while the accelerator model is how the increase of GDP resulting from government spending can encourage firms to invest.
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?
They will have a similar effect but the government actions are the most effective to the level of GDP.
Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity.
Fiscal stimulus works very well when it comes to the increase of GDP. On the other hand, it also increases a country’s debt, but the hope is that the multiplier effect will increase the GDP to more than what was initially injected.
1. Economists calculate the multiplier by dividing the eventual change in GDP by the amount of the injection into the economy.
2. The main leakage from the multiplier effect is the marginal propensity to save. When consumers receive a dollar, they won’t spend all of it. They’ll save some of it. Another leakage is money that’s spent on imports. These will reduce the effect that something such as tax cuts will have on the economy.
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.
4. They would probably be fairly similar. I would guess, though, that they would be smaller. Government actions seem to me to be the most effective policies that can change the level of GDP.
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.
Sara,
You mention the potential long-term threat of inflation, which is a clear in the current worries among many governments about when to end stimulus. The general conclusion thus far is that it should be sustained until the recovery takes hold. After that, you are right in that this policy will be inflationary.
Laura
1. Economists calculate the multiplier of government spending to GDP by dividing the change in the GDP versus the amount of money spent by the government
2. Leakages from the circular flow represent money being saved and such which leads to the loss of the money from the flow. More or less the money is pocketed by one owner as opposed to being passed on to keep moving. This negatively affects businesses.
3. The accelerator model of Governmental Spending is directly affected by the multiplier arguing that increasing governmental spending will lead to an increase in incentives for companies and firms to work.
4. Multipliers for other injections would most likely be smaller due to the fact that straight government spending is more likely to be evenly distributed into the economy
5. I would argue that a Fiscal Stimulus is a very effective plan to increase the level of economic activity. This is its primary purpose and by increasing the amount of money in the fiscal cycle this leads to an increase in GDP and economic activity.
Laura:
It’s interesting how much you see the fiscal stimulus as depending upon the individual people involved. Do you think there are any ways to encourage people to spend the money they receive and educate them or do you think it is easier and more successful to just let them (the people) spend it.
1. Dividing the change in GDP by the amount of money spent
2. They might be savingsof people.
3. The spendings by the government has a multiplier effect of increasing the GDP by more than what was spent,this causes an increase in investment. Meanign the spending by the government cuases an increase in GDP and investments.
4. They would be siimilar to the former spendings, but mostlikely. The government actions are the most effective policies that can change the level of GDP.
5. Fiscal stimulus is an aid to recover from recession as it boosts aggregate demand, but after economic growth has been achieved, they only create inflationary pressures.
Hi Marcelo,
In your question 4 I agree that these will be lower, but I think they will reamin just abi lowe than the former, meaning similar to the previous spendings.
Armando
1. How do economists calculate the multiplier?
Economists do so by taking the the change in GDP and dividing it by the total money spent by the government.
2. What are leakages from the circular flow that reduce the multiplier effect?
The saving of capital by a consumer or business, as capital does not continue to flow throughout the circular flow.
3. Explain the link between the accelerator model and the multiplier.
The link between the accelerator model and the multiplier is that they are both linked to the initial injections into an economy. The multiplier sums up the effect that an initial amount of government spending or cuts in taxes has on the consumer behaviour. i.e. spending
While the accelerator model is how the increase of GDP results from government spending can encourage firms to invest.
4. 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?
They would have the same affect, however government spending reaches out to everybody so it in theory it would have more effect.
# Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity