Coursework: MPP

IMT Ghaziabad
By
Dr. Manas Paul
Term II PGDM 2015-17

Keynesian Multipliers
Keynesian model of income determination
Consumption function
Multipliersimpact of autonomous spending
on output
Impact of income tax on multipliers
Effect of Govt purchases and tax changes on
govt finances/govt budget

Post crisis fiscal boost

Source: Pg. 08 of IMF Macroeconomic Policy Advice in the Financial Crisis Aftermath, Independent Evaluation
Office, IMF, BP/14/7 , by Sanjay Dhar , 08 Oct, 2014

US plan for a boost of $787bn; China boost of $586bn, EU a boost of $200bn

Autonomous Spending
YD Y TA TR
C C cYD C c(Y TR TA)

What is the slope of Consmption fn?

AD C I G NX
C c(Y TA TR ) I G NX

Making C a function of disposable income

What is the slope of Agg DD fn?

C c(TA TR ) I G NX cY
A cY

A [C c(TA TR ) I G NX ]

A bar is independent of the level of income or autonomous.

In equlbm Y = AD
i.e.
Y cY A
Y A cY
Solve for Y to find the eqlm output

Y (1 c ) A
1
Y0
A
(1 c )

Got to excel
Sheet Example
Example 1

Consumption, AD & autonomous spending

The Government Sector

The government affects the level of
equilibrium output in two ways:
1. Government expenditures (component of AD)
2. Taxes and transfers

Fiscal policy is the policy of the government

with regards to G, TR, and TA

Assume G and TR are constant, and that there is a proportional

income tax (t)

C C c(Y TR tY )

The consumption function becomes:

C cTR c(1 t )Y
The MPC out of income
becomes c(1-t)

The Government Sector

AD C I G NX

Combining with AD:

C cTR c(1 t )Y I G NX
A c(1 t )Y
Using the equilibrium condition, Y=AD, and equation the
equilibrium level of output is:
Y A c(1 t )Y
Y c(1 t )Y A
Y 1 c(1 t ) A
Y0

A
1 c(1 t )

The presence of the government sector flattens the AD curve

and reduces the multiplier to
1
(1 c(1 t ))
9-7

Effects of a Change in Fiscal Policy

Suppose government
expenditures increase

[Insert Figure 9-3 here]

Results in a change in
autonomous spending and
shifts the AD schedule upward
by the amount of that change
At the initial level of output, Y0,
the demand for goods > output,
and firms increase production
until reach new equilibrium (E)

How much does income

expand? The change in
equilibrium income is
Y0

1
G G G
1 c(1 t )

9-8

Effects of a Change in Fiscal Policy

Y0

1
G G G
1 c(1 t )

A $1 increase in G will lead to

an increase in income in
excess of a dollar
If c = 0.95 and t = 0.25, the
multiplier is 3.5
A $1 increase in G results in an
increase in equilibrium income
of $3.50
G and Y shown
Expansionary fiscal policy measure

[Insert Figure 9-3 here]

Effects of a Change in Fiscal Policy

Suppose government increases TR instead
Autonomous spending would increase by only cTR,
so output would increase by G cTR
The multiplier for transfer payments is smaller than
that for G by a factor of c
Part of any increase in TR is saved (since considered income)

If the government increases marginal tax rates,

two things happen:
The direct effect is that AD is reduced since disposable
income decreases, and thus consumption falls
The multiplier is smaller, and the shock will have a
smaller effect on AD

Effects of Government Purchases

on Budget Surplus
An increase in G reduces the surplus, but also increases
income, and thus tax revenues
Does there exist a Possibility that increased tax
collections overwhelms the increase in G????

The change in income due to increased G is equal to

Y0 G G , a fraction of which is collected in taxes
Tax revenues increases by tG G
The change in BS is
BS TA G
t G G G

When the tax rate

remains unchanged,
an increase in Govt
spending can not
generate tax revenues
The change
is
more
than it..

(1 c)(1 t )
G negative OR
1 c(1 t )
reduces the surplus

Balanced budget multipliers

We have seen earlier:
In the case of (proportional) tax rate remaining unchanged, tax revenues earned from
multiplied income (fiscal multiplier effect) at the back of a rise in govt spending would
always fall short of the govt spending made.
So what if along with Govt spending the tax rate also changes?
Can we get a solution where the increase in tax collection at the back of multifold rise
in Y and an increase in tax rate t can match the increase
in government spending?
If so happens then we arrive at the situation of balanced budget multiplier..
We do this in terms of lump-sum taxes where balanced budget implies: G TA

Balanced budget multipliers: Using Lump sum taxes

Balanced Budget implies:

G = TA
Hence,

Now we have seen earlier that in such a case

Y = A +cY
= +

Now change in autonomous spending will have two components.

1. First increase in Govt spending G.
2. Second the reduction in disposable income due to taxes will lead to a
reduction in domestic consumption =
Replacing A in the equation above for Y:

= +

Since G = TA : = +
(1-c) = (1-c) => =

What is the value of balanced budget multiplier?

Balanced budget multipliers:

Cute construct but unlikely to be so relevant
Political difficulty to use the balanced-budget multiplier ..people are bound to notice
that the benefits of the plan go disproportionately to the unemployed, while most of
the costs are borne by the majority who are working..
Pursuing balanced-budget stimulus requires raising taxes. voters are extremely
sensitive to the very words tax increase.

Automatic Stabilizers
What are they?
Automatic Stabilizers: Factors /arrangements those reduces the impact
of short-run fluctuationshence dampens the multiplier impact without additional
government intervention i.e.
Proportional taxation: Reduces the multiplier. Hence dampens the rise in
Income during expansions and similarly it makes any downturn less severe.
Unemployment benefits: During and after recession as more an more people loose
jobs, they automatically come under the unemployment benefit which reduces
the impact of income loss at back of job losses.
Similarly as during a recovery as more and more job gains happens people start
exiting from the unemployment benefit programs.
What do they do?
They reduces the severity of downturn and at the same time prevents the
economy from overheating during recovery.

Example:

We have an economy described by the following functions:

C 50 0.8YD
_

I 70
_

G 200
_

TR 100
t 0.20

a. Calculate the equilibrium level of income and multiplier in the model

b. Calculate the budget surplus/deficit
c. Suppose t increases to 0.25, what would be the equilibrium income and new
multiplier?
d. Calculate the change in the budget surplus/deficit. Would you expect the change in
surplus/deficit to be more or less if c=0.9 rather than 0.8?
e. Can you explain why the multiplier is 1 when t=1?

Assignment 1:
You as a part of IMF Mission have been deputed to analyse and suggest possible fiscal
boosters to two island economies run down by financial crisis. These two economies
were hit by economic crisis in the previous year. Economy 1 had a nominal GDP of USD
700 and Economy 2 had a nominal income of USD 800, while their GDP deflator declined
by 5% and 7% respectively from the base year. The two economies are characterised by:
These are in real terms
Economy 1
C=50 +0.8YD
I bar = 70
G bar = 200
TR = 100
t=0.2

1.
2.
3.
4.

5.

6.

These are in real terms

Economy 2
C=50 +0.85YD
I bar = 70
G bar = 200
TR = 100
t=0.15

Find yoy growth in real GDP in both these economies.

What are the value of autonomous spending in both these economies?
Apparently there is hardly any difference in autonomous spending between these two economies? What could be the
reason for higher growth in one of these economies?
Because of rising dissent at the back of increased economic difficulties, finance ministers in both these economies are
advocating transfers to the masses over government spending? Explain to what extent you would veto their
recommendation?
Finance ministers of both these countries were of the view that they can fund an increase in government spending
through rising tax collections even if there is no increase in tax rate just because of the manifold rise in income at
the back of multiplier effect. Can you find that level of government spending for these countries that can be funded
through rising tax collections just because of the multiplier effect?
Now along with a rise in government spending the government also has the option of raising the tax rate. Can you find
a combination rise in taxes and government spending for both these countries when the entire rise in government
spending can get funded through the rising tax revenues?

Assignment 2:

Suppose tax revenue take the functional form

= ( + ), where is autonomous tax independent of income.
Consumption function takes the form given below, while I, G, (X-M) are
autonomous.

C C cYD C c(Y TR TA) C c(Y TR (( tY ))

1.

Find the formula for multiplier is it different from the multiplier where you had only proportional tax without
any autonomous element?

2.

What is the value of equilibrium Y, is it lesser or more than the case without proportional income? Can there
be an explanation for the same?

3.

Can you prove the case of balanced budget multiplier with a change in autonomous component of
of the tax?