Question

Write short notes on the following: (a) Government expenditure multiplier (b) Tax multiplier

Short answer

Question: Explain the difference between the government expenditure multiplier and the tax multiplier. Answer: The government expenditure multiplier and the tax multiplier are both measures of the impact on GDP due to changes in fiscal policy. The key difference between them lies in their focus. The government expenditure multiplier measures the change in national income or GDP resulting from a change in government spending. It shows how much additional output (GDP) is created in the economy for every unit increase in government spending. The multiplier effect is due to the induced consumption that arises from the initial increase in spending. The government expenditure multiplier is typically greater than one, meaning that an increase in government spending has a multiplied effect on output. On the other hand, the tax multiplier measures the change in national income or GDP resulting from a change in tax revenues. It shows the impact of changes in taxation on GDP. The tax multiplier is negative, indicating that an increase in taxes will reduce GDP by a multiplied amount, while a decrease in taxes will increase GDP. The absolute value of the tax multiplier is generally smaller than that of the government expenditure multiplier, which means that changes in taxes have a smaller effect on output compared to changes in government spending. The tax multiplier is negative because taxes reduce disposable income, leading to decreased consumption and output.

Step-by-step solution

(a) Government Expenditure Multiplier

The government expenditure multiplier is a measure of the change in national income (or Gross Domestic Product - GDP) resulting from a change in government spending. In other words, it shows how much additional output (GDP) is created in the economy for every unit increase in government spending. The government expenditure multiplier can be derived based on the Keynesian model and is represented mathematically as: Government expenditure multiplier = 1 / (1 - marginal propensity to consume) Where the marginal propensity to consume (MPC) is the proportion of each additional dollar of income that is spent on consumption. The government expenditure multiplier is greater than one, which means that an increase in government spending has a multiplied effect on output. This occurs because the initial increase in spending not only generates output directly but also has indirect effects on demand and further spending by other sectors of the economy through a process called "induced consumption."

(b) Tax Multiplier

The tax multiplier is a measure of the change in national income (or GDP) resulting from a change in tax revenues. It shows the effect of changes in taxes on the output or on the GDP. The tax multiplier differs from the government expenditure multiplier because it refers to changes in taxation revenue rather than changes in government spending. The tax multiplier can also be derived based on the Keynesian model and is represented mathematically as: Tax multiplier = -MPC / (1 - MPC) Notice that the tax multiplier is negative, which indicates that if taxes are increased (or decreased), the GDP will decrease (or increase) by a multiplied amount. The explanation for the negative sign is that taxes reduce disposable income, which leads to a decrease in consumption and, consequently, output. The absolute value of the tax multiplier is smaller than that of the government expenditure multiplier, which implies that changes in taxes have a smaller effect on output compared to changes in government spending.