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Chapter 27: Problem 8

A Federal Reserve publication argued that the size of the multiplier "depends on the type of fiscal policy changes in question and the environment in which they are implemented." a. What does the author mean by "the type of fiscal policy changes in question"? Why does the type of policy matter for the size of the multiplier? b. What does the author mean by "the environment in which they are implemented"? Would the size of the multiplier be affected by how close real GDP is to potential GDP? Briefly explain.

Short Answer

Expert verified
The 'type of fiscal policy changes in question' signifies whether the change is about taxation, government expenditures or both, as different policies impact the economy differently, hence varying the multiplier size. The 'environment in which they are implemented' alludes to the prevailing economic conditions at the time of fiscal policy enforcement. Yes, the proximity of real GDP to potential GDP influences the size of the multiplier, as it indicates whether the economy is at its full potential or not, thus impacting the multiplier effect.

Step by step solution

01

Understanding Fiscal Policy Changes

Fiscal policy changes refer to the government decisions about taxation and government spending. When the government increases or decreases taxes, or alters its spending, these are considered fiscal policy changes. The type of fiscal policy change in this context could refer to whether it’s expansionary or contractionary. Essentially, it could also refer to whether the change is in tax policies, government spending policies, or a combination of both.
02

Reasoning the impact of policy type on Multiplier

The multiplier could be affected by the type of policy because different policies have different levels of impact on the economy. For instance, an increase in government spending typically has a direct effect on demand and can increase economic activity more quickly, leading to a possibly larger multiplier effect. On the contrary, a decrease in taxation might lead to an increase in consumer spending, but the effect could be less immediate or less certain because consumers may choose to save the extra income instead of spending it. Hence it might have a smaller multiplier effect.
03

Understanding the implementation environment

The environment in which they are implemented could refer to the current state of the economy when the changes in fiscal policy are made. It could mean a variety of factors such as the time period, the economic cycle the country is going through (recession or boom), current interest rates, inflation, level of unemployment, and so on.
04

Assessing the influence of GDP on Multiplier

The gap between real GDP and potential GDP can certainly affect the size of the multiplier. If the real GDP is much lower than the potential GDP, implying that the economy is in a recession or a slump, an expansionary fiscal policy might have a larger multiplier effect as there is a lot of idle capacity in the economy. Conversely, if real GDP is close to potential GDP, implying that the economy is at or near full capacity, then a further increase in government spending might simply lead to inflation rather than an increase in output, thus having a smaller multiplier effect.

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Most popular questions from this chapter

Is it possible for Congress and the president to carry out an expansionary fiscal policy if the money supply does not increase? Briefly explain.

Some economists argue that because increases in government spending crowd out private spending, increased government spending will reduce the long-run growth rate of real GDP. a. Is this outcome most likely to occur if the private spending being crowded out is consumption spending, investment spending, or net exports? Briefly explain. b. In terms of its effect on the long-run growth rate of real GDP, would it matter if the additional government spending involves (i) increased spending on highways and bridges or (ii) increased spending on national parks? Briefly explain.

What are the key differences between how we illustrate a contractionary fiscal policy in the basic aggregate demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply model?

Economist Mark Thoma observed, "One of the difficulties in using fiscal policy to combat recessions is getting Congress to agree on what measures to implement.... Automatic stabilizers bypass this difficulty by doing exactly what their name implies." What are automatic stabilizers? Name two examples of automatic stabilizers and explain how they can reduce the severity of a recession.

Write the equation that links real GDP growth to its two determinants. Briefly explain why the relationship indicated by the equation holds.
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