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.

Key concepts

Tax Multiplier

The tax multiplier is an interesting concept in economics that helps understand how changes in tax policy can impact the economy. It measures the effect on national income (or GDP) from a change in tax revenues. Imagine this as how much the GDP shifts when the government decides to increase or decrease taxes.
It is important to note that the tax multiplier is negative. This means that an increase in taxes leads to a decrease in GDP, while a decrease in taxes results in an increase in GDP. This happens because taxes influence the amount of disposable income people have.

• Higher taxes mean less disposable income, reducing consumption and thus reducing GDP.
• Lower taxes increase disposable income, boosting consumption and thus increasing GDP.

The mathematical formula for the tax multiplier is:\[\text{Tax Multiplier} = - \frac{MPC}{1 - MPC}\]Here "MPC" stands for "marginal propensity to consume," which is a key factor in determining how consumption changes with income. The tax multiplier's absolute value is generally smaller than the government expenditure multiplier, indicating that tax changes affect GDP less dramatically than government spending changes.

Keynesian Model

The Keynesian Model, named after economist John Maynard Keynes, forms the backbone for understanding both the government expenditure multiplier and the tax multiplier. This model emphasizes the role of aggregate demand in influencing overall economic activity.
At its core, the Keynesian model suggests that total spending in an economy (aggregate demand) drives production and thus affects the level of economic output and employment. In times of economic downturns, the model advocates for increased government spending to stimulate demand. This is where multipliers come into play.

• The government expenditure multiplier shows how government spending can lead to more significant changes in GDP.
• The tax multiplier shows how tax changes can influence GDP.

In the Keynesian view, fiscal policy—government adjustments to spending and taxation—is crucial for managing the economy, especially for stabilizing booms and busts. It argues that direct interventions can greatly help in improving economic performance during periods of instability.

Marginal Propensity to Consume

The concept of marginal propensity to consume (MPC) is fundamental in understanding both the government expenditure and tax multipliers. MPC refers to the proportion of any additional income that a consumer spends as opposed to saving.
Imagine you get an extra dollar. The MPC is the fraction of that dollar that you decide to spend. For instance, if you choose to spend 80 cents and save 20 cents, your MPC is 0.8.
The formula for the government expenditure multiplier includes MPC, showing the ripple effect of spending in the economy:\[\text{Government Expenditure Multiplier} = \frac{1}{1 - MPC}\] Similarly, MPC affects the tax multiplier formula:\[\text{Tax Multiplier} = - \frac{MPC}{1 - MPC}\]Here's why MPC is so vital:

• Higher MPC means more consumption from additional income, amplifying economic activity.
• Lower MPC suggests more income gets saved, dampening the impact on economic activity.

Understanding MPC helps economists predict consumer spending behaviors and the overall effect on GDP when there's a fiscal change in policies.