Nov 24 2008

## The Multiplier Effect as it applies to the Obama camp’s fiscal stimulus proposal

Below is the explanation of the “Multiplier effect” from our class wiki, as explained by my Econ students:

Multiplier = 1/(1-MPC) = 1/MPS
Multiplier = change in real GDP/ initial change in spending
Change in GDP = mutlplier x the initial change in spending

Rationale: The multiplier is explained based on the following facts:

• The economy supports repetitive, continuous flows of expenditures and income
• Any change in income will vary both consumption and saving in the same direction as, and by a fraction of, the change in income
• Initial change in spending will set off a spending chain throughout the economy
• Chain of spending, although of diminishing importance at each successive step, will accumulate and result in a multiple change in GDP

Harvard Economist Gregory Mankiw has applied the concept of the spending multiplier to the proposal coming from Barack Obama’s economic transition team to inject as much as \$700 billion of goverment spending into the economy to stimulate aggregate demand and help America escape its recession. Mankiw quotes today’s Washington Post:

Facing an increasingly ominous economic outlook, President-elect Barack Obama and other Democrats are rapidly ratcheting up plans for a massive fiscal stimulus program that could total as much as \$700 billion over the next two years….Obama has set a goal of creating or preserving 2.5 million jobs by 2011.

Mankiw, the Econ teacher that he is, applies the basic formula for the Spending Multiplier to the numbers coming from the Obama camp, and finds the following:

Dividing one number by the other, that (the \$700b of government spending) works out to \$280,000 per job.

What is going on here? Logically, it must be one of three possibilities:

1. The fiscal stimulus is going to be much smaller than is being reported.
2. The new administration is setting a low bar for itself when it comes to job creation.
3. The Obama team believes in very small fiscal policy multipliers.

Let me amplify the last point. The average weekly earnings of production and nonsupervisory workers is about \$600, or about \$60,000 over a two-year period. Granted, labor income is only about two-thirds of national income, and we have to add a few supervisors into the mix.

So let’s say each job created means \$100,000 of extra national income. If we are generating \$100,000 of income with \$280,000 of government spending, the multiplier is only 100/280, or 0.36. Traditional Keynesian models suggest a multiplier closer to 2.0.

What Mankiw has found, using simple economic analysis understood by anyone who has studied AP or IB Economics, is that if we believe in the numbers given by the Obama camp itself, then government spending package of \$700 billion will result in roughly \$250 billion of new income for the nation.

How did we find this? Simply by applying the forumula given on our wiki above: Multiplier = change in real GDP/ initial change in spending, and plugging in the numbers calculated by Mankiw:

• Multiplier = 0.36.
• Change in spending = \$700b.
• Therefore, the change in national income (or GDP) equals \$700b x 0.36 = \$252 billion

Perhaps Mr. Obama needs to consider the basic economic principle of the Spending Multiplier before he goes around throwing out numbers about the jobs that will be created or preserved from a new fiscal stimulus package. Clearly, 2.5 million jobs grossing an average of \$100,000 each over two years, while SOUNDING good, in reality represents a truly unbelievable squandering of wealth and income by the US government.

Jun 04 2008

## The “teenager tax” – why expansionary fiscal policy just ain’t fair!

FT.com / Weekend columnists / Tim Harford – Why a tax cut just isn’t fair on teenagers

Tim Harford, aka The Undercover Economist, loves to expose the overlooked effects of governments’ economic policies. For example, both the United States and the UK have recently announced tax cut and rebate plans aimed at putting hundreds of dollars back into the hands of taxpayers, with the hope that households will spend their “free money” from the government, giving the national economies a much needed boost in a time of economic slowdown.

Expansionary fiscal policy, as such a tax cut is known, is a popular tool in times of macroeconomic slowdowns. The hope, of course, is that taxpayers who experience sudden fiscal relief will rejoice upon their newfound disposable income, spending it on goods and services, creating new income for various sectors of the economy, which in turn will be spent on more goods and services. In economics, we call this the “multiplier effect”, the idea being that a certain tax cut (say \$150 billion), will ultimately create some multiple of that amount in new spending and income throughout the economy as a whole.

In reality, however, house holds do not spend 100% of a tax rebate or tax cut like those recently passed in the US and the UK. When disposable income increases, household will spend a certain proportion and save or pay off past debts with the rest. The proportion of new income spent is determined by an individual’s marginal propensity to consume, and the proportion saved is based on his or her marginal propensity to save. The greater proportion of additional income that is spent, the larger the multiplier effect in the economy as a whole, and the greater impact expansionary fiscal policy will have towards achieving growth in the economy.

Policy makers, therefore, prefer households spend, rather than save, new income from a tax cut or rebate. According to the Undercover Economist, however, saving a tax rebate is precisely what smart households will do. Why? Because of the basic economic truth learned in the first week of most principles of economics courses: There’s no such thing as a free lunch! Tim Harford explains:

…since neither the UK nor US governments plans to alter its spending plans, these tax holidays will be funded by government borrowing – borrowing that must eventually be repaid. That will require taxes to go up in the future, or not to fall when they otherwise might.

Who should celebrate? Not the typical taxpayer, that is for sure. The tax cut makes no difference to her. If she – assume she is British – had wanted an extra £120 right now, she could already have it in her pocket, either by withdrawing it from savings or by borrowing the money. If she did that, of course, she would later have to repay £120 plus interest. But that is exactly what Darling’s successor as chancellor will require of her. To look at it another way, the rational taxpayer should save the £120 windfall now, keeping it to pay the higher taxes that are surely on the horizon.

A tax rebate financed through government borrowing does not make American or British households any better off. Imagine a scenario where your buddy is experiencing some financial difficulties (maybe he’s lost his job, maybe he’s experienced an expensive injury and has no health insurance…), so you decide you’ll help him out by throwing some cash his way. The catch is, you’re already in debt and have spent more in the last couple of years than your actual income should have allowed. So, in order to help your buddy out, you actually need to borrow money from him. So you give him an IOU, he scrounges up the little cash he can find, gives it to you for the IOU, and you turn around and give it back to him to “help him out.” You can imagine, your buddy is not very thankful and certainly doesn’t feel any richer.

On the macro level, the cash mailed out to American households as part of the recent stimulus package came from new borrowing by the government from American households. All those IOUs issued to finance the stimulus must be paid back, and must be done so through future tax increases. The government has chosen to forgo future spending in order to stimulate current spending. Not everyone should dismay, however, as a certain lucky group will clearly benefit from today’s debt-financed fiscal stimulus packages:

…some people should count themselves wealthier after the tax cut. Anyone expecting to die without making a bequest should be pleased: if the Grim Reaper knocks on the door before the taxman does, he can spend the tax rebate now and leave the bill for some other sucker.

Who will be the fall guy? We don’t know for sure, because we can’t say who a future government will tax. But an obvious candidate would be today’s teenagers, very few of whom are paying income tax right now, but most of whom will pay it in the next few years. Their best hope is that their grandparents add the tax windfall to their bequests rather than blowing the money on a weekend in the sun.

A tax cut today almost certainly implies a tax increase tomorrow. Since teenagers enjoy almost none of the tax cuts today, but will bear the future increases required to pay back new debt, it is you, my students, who should be most opposed to the shortsighted policies being undertaken by US and UK policy-makers.

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