Question

We saw that in calculating the stimulus package's effect on real GDP, economists in the Obama administration estimated that the government purchases multiplier has a value of 1.57 . John F. Cogan, Tobias Cwik, John B. Taylor, and Volker Wieland argued that the value is only 0.4 . a. Briefly explain how the government purchases multiplier can have a value of less than 1 . b. Why does an estimate of the size of the multiplier matter in evaluating the effects of an expansionary fiscal policy?

Short answer

The government purchases multiplier can have a value of less than 1 if certain conditions are present in the economy, such as high levels of taxes, saving rates, and interest rates or low utilization of capacity, which can limit the extent to which increases in government spending result in increases in GDP. The size of the multiplier matters in evaluating the effects of an expansionary fiscal policy because it determines the extent to which changes in government spending translates into changes in GDP. A larger multiplier means a larger increase in GDP for a given increase in government spending, while a smaller multiplier implies a smaller increase in GDP, hence it becomes crucial in policy planning and evaluation.

Step-by-step solution

Understand the Multiplier Concept

The government purchases multiplier is an economic measure used to determine the effect an increase in government purchases will have on the country's Gross Domestic Product (GDP). It measures the expected number of times that an increase in government spending will be 'multiplied' through its resultant impact on incomes and thus on consumption, ultimately leading to an increase in GDP. It is calculated based on the marginal propensity to consume (MPC), as well as other factors like tax rates and saving rates.

Explain Why the Multiplier Can be Less Than 1

A government purchases multiplier of less than 1 implies that an increase in government spending contributes less than proportionately to GDP. This could occur if the economy is not using all its capacity, thus government spending could crowd out private sector spending. Additionally, tax rates, interest rates, and saving rates all impact the multiplier effect. If these are high, then the extra income from increased government spending might be saved or taxed away, rather than spent, reducing the multiplier effect to less than 1.

Discuss Why the Multiplier's Size is Important

The size of the multiplier is crucial in evaluating the effects of an expansionary fiscal policy because it determines the scale upon which changes in government spending will change the level of GDP. A larger multiplier means that a given increase in government spending will have a larger impact on GDP; alternatively, a smaller multiplier would mean that the same increase would have a smaller effect on GDP. Therefore, estimating the multiplier's value becomes important for policy makers as it helps them anticipate and quantify the expected impact on GDP from changes in fiscal policy.

Key concepts

Expansionary Fiscal Policy

Expansionary fiscal policy involves the use of government spending and tax policies to stimulate economic growth. When the government opts to increase spending, cut taxes, or both, it aims to boost overall demand in the economy. This stimulation of demand contributes to higher levels of output and employment.

For instance, when a government constructs new roads, it directly pays construction workers and suppliers, thereby increasing their income. Those workers can then spend their increased income on other goods and services, which can lead to even further economic activity. However, the effectiveness of expansionary fiscal policy heavily depends on the context of the current economic environment and the responsiveness of spending entities, that is, how much of their additional income they spend versus save—a concept encapsulated in the marginal propensity to consume (MPC).

Gross Domestic Product (GDP)

Gross Domestic Product, or GDP, is the total monetary or market value of all the finished goods and services produced within a country's borders in a specific time period. As a broad measure of overall domestic production, it functions as a comprehensive scorecard of a given country's economic health.

GDP can be affected by various factors, including investment, consumption, government spending, and net exports. When analyzing the impact of government actions on GDP, economists often look into fiscal policies and how they might increase economic output. For example, during a recession, the government may use expansionary fiscal policy to increase GDP and mitigate the downturn's effects.

Marginal Propensity to Consume (MPC)

The Marginal Propensity to Consume (MPC) is a crucial economic concept that measures the proportion of additional income that a household is expected to spend on consumption rather than saving. It is a number between 0 and 1 and is key to understanding the multiplier effect in economics.

The higher the MPC, the more of each dollar of new income that will be spent, thereby amplifying the initial impact of any increase in government spending. Conversely, a lower MPC suggests more of each dollar will be saved, which dampens the economic impact of government spending increases.

Fiscal Policy impact on GDP

Fiscal policy, comprising government spending and taxation, directly influences Gross Domestic Product (GDP) by altering aggregate demand. When the government enacts expansionary fiscal policy, by increasing its purchases for example, there is a direct increase in the level of demand for goods and services, which can increase GDP.

However, the actual change in GDP stemming from such government spending is also dependent on the government purchases multiplier. The multiplier illustrates how initial spending leads to increased consumption, investment, and potentially further rounds of spending, echoing throughout the economy and magnifying the initial fiscal stimulus. A high multiplier value, as assumed by some economists, indicates a greater impact on GDP, while lower values suggest a more modest effect. This is why debates over the actual multiplier value—like the one presented in the textbook exercise—shape expectations and discussions regarding fiscal policy's efficacy in promoting economic growth.