Assume the government increases spending by $100 billion in the each of the next three years from now. Economists estimate the spending multiplier to be 1.5 and the impact is immediate and exhausted in each year. They also estimate the tax multiplier (which captures the impact of rising tax rates on GDP) to be equal to 1 and the current average tax rate is equal to 30 per cent. What is the cumulative impact of this fiscal expansion on GDP after three years?
Answer: $450 billion.
The answer was $450 billion.
In Year 1, government spending rises by $100 billion, which leads to a total increase in GDP of $150 billion via the spending multiplier. The multiplier process is explained in the following way.
Government spending, say, on some equipment or construction, leads to firms in those areas responding by increasing real output.
In doing so they pay out extra wages and other payments which then provide the workers (consumers) with extra disposable income (once taxes are paid).
Higher consumption is thus induced by the initial injection of government spending.
Some of the higher income is saved and some is lost to the local economy via import spending.
So when the workers spend their higher wages (which for some might be the difference between no wage as an unemployed person and a positive wage), broadly throughout the economy, this stimulates further induced spending and so on, with each successive round of spending being smaller than the last because of the leakages to taxation, saving and imports.
Eventually, the process exhausts and the total rise in GDP is the 'multiplied' effect of the initial government injection.
In this question we adopt the simplifying (and unrealistic) assumption that all induced effects are exhausted within the same year. In reality, multiplier effects of a given injection usually are estimated to go beyond 4 quarters.
So this process goes on for 3 years so the $300 billion cumulative injection leads to a cumulative increase in GDP of $450 billion.
It is true that total tax revenue rises by $135 billion but this is just an automatic stabiliser effect. There was no change in the tax structure (that is, tax rates) posited in the question.
That means that the tax multiplier, whatever value it might have been, is irrelevant to this example.
Some might have decided to subtract the $135 billion from the $450 billion to get answer (c) on the presumption that there was a tax effect. But the automatic stabiliser effect of the tax system is already built into the expenditure multiplier.
Some might have just computed $135 billion and said (a). Clearly, not correct.
Some might have thought it was a total injection of $100 billion and multiplied that by 1.5 to get answer (b). Clearly, not correct.
You may wish to read the following blog posts for more information:
That is enough for today!
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