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E C I G = + +
( ) S T G +
, , E C S
0 1 0
I I I r =
0
Y
1
Y
8. Characterization the multiplier with government
Assuming G = G0 and T = T0, the aggregate demand for the economy is
Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 5
E(Y, r) = C(Y) + I(r) + G
As C =C0 + c1(Y T0), I(r) =I0 - I1r and G = G0
E(Y, r) = C0 + c1(Y T0) + I0 - I1r + G0 = [C0 - c1T0 + G0 + I0 - I1r] + c1Y
This can be written as E(Y, r) = A(T0, G0 , r) + c1Y
At equilibrium, E(Y, r ) = Y. This means A(T0, G0 , r)+ c1Y = Y
Hence,
0 0
1
1
( , , )
1
Y A T G r
c
=
and
1
1
1
c
is the multiplier.
As 1
1
1
1
>
c
, if we have a slight change in A, there will be a greater change in the
equilibrium level of Y. This is called Multiplier Effect.
Notice that the autonomous component A(T0, G0 , r) is now a function of interest rate,
government spending and taxes. Given that the economy's multiplier is greater than 1,
fiscal policies (government policy on G and T) that increase the autonomous component
of demand will increase output. This is main idea of the Keynesian model.
Exercise:
a) Show an increase in the government spending by 1 unit will increase output by
1
1
1 c
units.
b) Show an increase in the tax by 1 unit will decrease output by
1
1
1
c
c
unit.
c) Show the net impact on the equilibrium output following an increase in government spending
of G and a simultaneous increase in tax of T when G = T.
Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 6
Exercise:
Derive the multiplier in an economy with a proportional tax system assuming G = G0. Compare
the size of the multipliers under a lump-sum tax system and under a proportional tax system.
Example:
Here is a model of a closed economy:
C(Yd ) = 80 + 0.8 Yd ; I(r0) = 100 (short form of writing I =I0 I1r); G = 100 where Yd is
disposable income. Consider two tax systems (and a balanced budget policy); a lump-sum tax (G
= T0) and a proportional tax (G = T(Y) = tY). Will the equilibrium level of output be different
under the two tax systems? What will be the level of it?
Solutions:
We assume that Government collects same level of tax under two systems, further, there is a
government budget balance under both system. i.e., tax collected is just enough to pay for
government spending. Specifically,
Lump-sum tax: G = T0
Proportional tax: G = tY
In the case of lump-sum tax system, the aggregate demand of the economy is,
E(Y, r) = C(Y, T) + I(r0)+G
C =C0 + c1(Y T0); I(r0) = I0(r0) and G = G0
Thus,
E(Y0, r0) = C0 + c1(Y T0 )+ I0(r0) + G0
= [C0 - c1T0 + G0 + I0(r0)]+ c1Y
At equilibrium, E(Y, r0) = Y
So, [C0 - c1T0 + G0 + I0(r0)]+ c1Y = Y
Hence, Y = [C0 - c1T0 + G0 + I0(r0)]
1
1
1
c
with
1
1
1
c
is the multiplier.
Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 7
As, G = T = 100,
Y = [C0 - c1T0 + G0 + I0(r0)]
1
1
1
c
= [80 0.8 100 + 100 + 100]
8 . 0 1
1
= 1000
In the case of proportional tax system, the aggregate demand of the economy is,
E(Y, r0) = C(Y, T) + I(r0)+G
C =C0 + c1(Y tY); I(r0) = I(r0) and G = G0
Thus,
E(Y, r0) = C0 + c1(Y tY)+ I(r0) + G0
= [C0 + G0 + I(r0)] c1tY + c1 Y
= [C0 + G0 + I(r0)] + c1(1 t ) Y
At equilibrium, E(Y, r0) = Y
So [C0 + G0 + I(r0)] + c1(1 t ) Y = Y
Hence, Y = [C0 + G0 + I(r0)]
) 1 ( 1
1
1
t c
with
) 1 ( 1
1
1
t c
is the multiplier.
[C0 + G0 + I(r0)] = 80 + 100 + 100 = 280
But t is not given. However, we know that T = G = tY, so, t = G/Y
The economys multiplier is thus,
) 1 ( 1
1
1
t c
=
1
1
1 (1 )
G
c
Y
=
1
100
1 0.8(1 )
Y
So, Y = 280
1
100
1 0.8(1 )
Y
Solving the above, Y = 1000.
In this economic system, the government sets t and adjusts G to be equal to tY. It is easy to
establish that there is a rate of tax, t = 10%, which will yield exactly the same equilibrium as
before, Y = 1000.
For any t > 10%, equilibrium will be at a lower level of output, while for any t < 10%,
equilibrium level of output will be greater than 1000
Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management Page 8
Homework
1. The effective marginal propensity to save is independent of whether there are lump-sum or
proportional taxes. True or false? Explain.
2. The effective marginal propensity to consume and the effective marginal propensity to save
add up to 1 only when there is a lump sum tax. True or false? Explain.
3. Derive the multiplier in an economy with a lump-sum tax system when the government
spending increases with national income.
4. Derive the multiplier in an economy with a proportional tax system when the government
spending increases with national income.
5. Compare the size of multipliers in question 3 and 4.
6. Assuming a lump sum tax system, find the multiplier of an economy where the poor (who get
the fraction of national income) do not pay tax but have the same marginal propensity to
consume as the rich. If there is a transfer of income from the rich to the poor, will there be
any effect on the multiplier.
7. A closed economy with the poor earning the fraction of national income. They do not
pay tax but have higher marginal propensity to consume than the rich. Assuming a lump
sum tax system, how would a transfer of income from the rich to the poor affect the
economy if wages and prices are fixed.