Friday, March 11, 2016

Spending Multiplier vs Taxing Multiplier

Spending Multiplier vs Taxing Multiplier

Multiplier formulas
Investment multiplier = 1/ (1-MPC) OR 1/ MPS
Spending or Government multiplier = 1/ (1-MPC) OR 1/MPS
Tax multiplier = - MPC x (1/MPS) OR - MPC/ MPS

2014 Macroeconomics #1 f

First, we need to understand the relationship between MPC/MPS. 
MPC is the marginal propensity to consume and the MPS is the marginal propensity to save.
Marginal meaning that it is the changes in income that are spent or saved.
If the MPC is 0.8, then 80% of a change in income will be spent,,, 
meaning that 20% will be saved. (MPS)

Expansionary Fiscal Policy
  • If the government increases spending by 100b then (GDP/AD/Incomes) will increase by the Spending Multiplier,, so,, 1/ (1-MPC) or 1/ (1-0.8)  = 1/0.2 = 5 x 100b = 500b increase in AD
  • If the government decreases taxes by 100b the (GDP/AD/Incomes) will increase by the        Tax Multiplier,, so,, -MPC/MPS,, so,, -0.8/0.2 = -4 x -100b = 400b increase in AD
  • Why the difference?? -  A tax decrease causes Disposable Income to rise,, but some that will be spent and some saved,,, while a increase in government spending is considered all spent.

Contractionary Fiscal Policy
  • If the government decreases spending by 100b then (GDP/AD/Incomes) will decrease by the Spending Multiplier, so, 1/ (1-MPC) or 1/ (1-0.8)  = 1/0.2 = 5 x -100b = -500b decrease in AD
  • If the government increases taxes by100b. (GDP/AD/Incomes) will decrease by the Tax Multiplier (hint: it is always 1 less than the Spending Multiplier),, so,, -MPC/ (1-MPC) or -80/ (1-0.8) or -80/0.2 = -4 x 100b = -400b decrease in AD
  • Why the difference?? - A tax increase causes disposable income to fall,, some of that tax increase will be paid out of savings.

Now,, 2014,, #1 f

If there is an equal increase in government spending and taxation will the Real GDP, Increase, Decrease or stay the same???

If the spending multiplier is 5 and increases government spending is 100b then 5 x 100b = 500b
If the taxing multiplier is -4 and government increases taxes by 100b then -4 x 100b = -400b

GDP would have increased by 500b + -400b = 100b


Nominal vs Real / Money Supply vs Loanable Funds

Fiscal Policy = Loanable Funds = Real Interest Rate  
Monetary Policy = Money Market = Nominal Interest Rate

1) Loanable Funds

Loanable funds graph has the real interest on the vertical axis and the quantity of loanable funds on the horizontal. The supply curves show the amount of loanable funds that people have saved and are willing to loan. The demand curve is the businesses and individuals that would like to borrow. 
Equilibrium shows the real interest rate for the country.

The real rate of interest is crucial in making investment decisions. Business firms want to know the true cost of borrowing for investment. If inflation is positive, which it generally is, then the real interest rate is lower than the nominal interest rate. If we have deflation, and the inflation rate is negative, then the real interest rate will be larger. (Pride)

Loanable Funds = Money in banks that can be loaned out to individuals and firms

The real rate of interest is: (an eye on the price level/inflation)
  • the opportunity cost of borrowing/loaning money 
  • expressed in constant dollars (inflation adjusted value) 
  • value or purchasing power of money used
  • percentage increase in purchasing power the borrower pays (adjusted for inflation)
The real interest rate measures the percentage increase in purchasing power the lender receives when the borrower repays the loan with interest. 

The supply of loanable funds is based on the savings of the private sectors.

2) Money Market

The money market graph has nominal interest rate on the vertical axis and the horizontal axis is labeled the quantity of money. The supply of money is perfect inelastic as the money supply is controlled by the FED. The demand for money curve is downward sloping. Price level changes will effect the demand for money as will interest rate changes.

The nominal rate of interest is:
  • the opportunity cost of holding money
  • expressed in current dollars  (non-inflation adjusted value)
  • price paid for the use on money (no eye on inflation)
  • percentage increase in money the borrower pays (not adjusted for inflation)
The supply of money is based on the actions of the FED.

Why Nominal rates ?? -  the money supply deals with inflation and nominal value, not real value, while an increase in the money supply is the cause of Price level changes (inflation). 

In the long run an increase in the Money Supply will cause the demand for money to increase and the Nominal Interest Rate to rise.

Thanks, Michelle,,