UNIVERSITY OF THE PHILIPPINES

SCHOOL OF ECONOMICS

ECONOMICS 100.1
Introduction to Macroeconomic Theory and Policy

Study Guide No. 2

Prof. Monsod / Mariano 1
st
Semester AY 2010-2011


Equilibrium, Fiscal Policy and the Multiplier Model


I. Learning Objectives

1. Explain the process by which a simple economy moves toward equilibrium if it is not initially at an
equilibrium position.
2. Derive the value of the multiplier from the marginal propensity to consume (MPC) and explain how the
multiplier is used to determine a new equilibrium position in a simple economy when investment spending
changes.
3. Understand how the multiplier model fits into the AS-AD model of the economy.
4. Understand how governmental fiscal policy affects output in the multiplier model.
5. Explain the different effects of taxes and government spending on aggregate demand.
6. Understand how the tax multiplier differs from the expenditure multiplier.


II. Summary (Chapter 22 of Samuelson and Nordhaus [2010])

1. In a simple, closed economy the intersection of the desired savings and investment schedules will
determine the equilibrium value of GDP. In order to simplify the analysis, Samuelson and Nordhaus (and
for that matter, most other principles text authors) make the assumption that investment spending is
exogenous. In other words, they treat investment spending as a given that is not determined by GDP. Or we
say that investment is independent of GDP.
When the economy is at equilibrium the desired spending and savings of households is equal to the desired
production and investment of firms. However, if households spend too little, or less than firms thought they
would, businesses are left with unsold goods. These unsold goods are added to business inventories and
count as part of investment. In this case, desired investment will be less than actual investment and the
economy will not be at an equilibrium position. In subsequent production periods, firms will produce less
and lay off workers. GDP falls and the economy moves toward a position where desired saving equals
desired investment.
The equilibrium position in the economy can also be found by comparing the total demand for goods and
services (C + I) with total output.
2. The multiplier is also critically linked to consumption. When firms invest more, the workers employed on
the investment project will earn more income. The MPC determines how much of their extra income they
will spend. The recipients of this spending will then turn around and spend more based on the MPC. The
analysis is simplified by assuming that the same MPC applies at all levels of income. Fortunately, in each
round marginal spending gets a little smaller (because some of the extra income is saved), and the process
converges. The result, however, is that GDP changes by some multiple of the initial investment project.
The more households spend, the larger that multiple will be.
3. The effectiveness of the multiplier in generating real changes in output depends upon how close the
economy is to full employment or potential GDP. If an economy is operating at close to full employment, it
will be difficult for a new investment project to generate more employment or output since the economy is
close to full employment already. At this point, higher levels of spending will add to the general level of
prices (inflation) and comparatively little to real output.
4. The multiplier model that we are working through can be traced back to Keynes. The focus of Keyness
attention in The General Theory (1936) was the Great Depression. Perhaps his development and discussion
of the multiplier was not overly concerned with changes in the price level, because inflation, at that point,
was hardly a concern for anyone.
5. In the simple model which we consider in the first part of the chapter, only two things could throw an
economy out of equilibrium: a decision to change the level of investment up or down and/or a decision to
change the level of consumption up or down. Either the I line must shift or the C line must shift. Without
one or the other of these shifts, a Keynesian equilibrium is, in this simple model, eternally durable.
6. Investment is, of course, inherently volatile. Disturbances to equilibria in simple models like ours are
therefore usually cast in terms of sudden, unanticipated changes in I, and that is the approach taken here.
The consumption function can also shift, to be sure, but the effects of such a shift are similar to the effects
of a change in investment.
7. The multiplier applies to both external and internal variables that influence and buffet the economy.
External changes include wars, the weather, and OPEC oil price changes. Some examples of internal
variables that affect the economy via the multiplier are government spending, taxes, and investment.
Sometimes these changes are expected, sometimes they are not. Sometimes these changes are very
beneficial and help stabilize the economy, and sometimes they do not. The main point here is that a solid
understanding of what multipliers are and how they influence the economy is critical to your understanding
of macroeconomics. Policymakers must have an appreciation for the working of the multiplier.
8. Economists have long recognized the role the government plays in providing collective or public goods and
redistributing income. Keynesian macroeconomic theory further defined the role of government to include
stabilizing the economy via active fiscal policy measures. Fiscal policy, when used appropriately, has a
significant impact on output, employment, and prices.
9. The government finances its expenditures by taxing (and borrowing). Lump-sum taxes, T are introduced
when a fixed sum of money is collected by the government as taxes, regardless of the level of output in the
economy. In this case, DI is no longer equal to GDP. However, the relationship between the two terms is
very direct: DI and T is now GDP.
10. Government spending (G), like investment is treated as exogenous with respect to GDP. This is not to say
that G cannot change. In fact, government spending will change frequently. This is precisely what fiscal
policy is all about. Total expenditure in the economy now equals C + I + G. (The only remaining term to
be added is net exports.)
11. If total expenditure in the economy exceeds the level of output, the economy will expand. Alternatively, if
C + I + G is less than the level of output, the economy will contract.
12. The effect of a change in G on GDP is exactly the same as a change in I. It represents a change in spending
outside of, or beyond, the consumption function. Therefore, the same expenditure multiplier can be used:
1/(1 - MPC) = 1/MPS.
13. The tax multiplier equals the expenditure multiplier times MPC. When the government changes taxes, there
will also be a multiplied effect on the economy. However, the tax multiplier will always be smaller than
the expenditure multiplier. Here is the reason: When the government raises taxes, households will not pay
for the additional tax entirely by reducing C. They will pay part of the tax increase by drawing down S.
Similarly, when taxes are reduced, households do not typically spend their entire tax cut. Part of the
newfound income is saved. Most likely you can appreciate the importance of the MPC in determining the
allocation of the tax between C and S. When taxes change, disposable income changes. The MPC
determines how much of the DI change is spent. This is the logic behind the tax multiplier.


III. Analytical Tools

1. Mathematical Analysis
a. Equilibrium in the economy
i. Model 1: Y = C
Assume that the only source of aggregate demand is consumption, C. Aggregate supply is the
total output produced by the firms in the economy denoted by Y.
The relationship between consumption and income is described by a linear function:
C a bY = + , where a is the autonomous consumption and b is MPC.
At equilibrium, AS=AD and thus, Y = C, i.e. all what is produced in the economy is used for
consumption. This also means that all of the income is spent for consumption, and therefore
savings, S is zero. We also call this equilibrium point as the break-even level.
The equilibrium output can be solved by replacing C a bY = + in Y = C, and we will get:
*
1
a
Y
b
=

.

ii. Model 2: Y = C + I
Let us now introduce investments into the aggregate demand: C + I.
Assume that investment spending is exogenously given: I I = . This is not to say that it
cannot change. There are factors that influence the decision of investors that increases or
decreases I . These are interest rates, income, taxes and expectations.
At equilibrium, aggregate supply equals aggregate demand: Y C I = + . Replacing C for
a bY + and I for I . The equilibrium output will then be:
*
1 1
a I
Y
b b
= +

.

b. Fiscal Policy
i. Model 3: Y = C + I + G
Now we include government in the model. According to Keynes, the role of government is to
push the economy into full employment. Through government spending, the aggregate
demand in the economy can be stimulated.
Let government spending be exogenously given: G G = .
Aggregate demand will now be C I G + + or ( ) a bY I G + + + . Equating AD with AS,
equilibrium output will then be:
*
1 1 1
a I G
Y
b b b
= + +

.


ii. Model 4a: Y = C + I + G (with lump-sum or head tax)
The primary source of government spending is taxation. There are three types of taxation:
lump-sum or head tax, proportional tax or progressive tax. We will only focus on lump-sum
tax and proportional tax.
Lump-sum tax is a fixed amount that is collected by the government. Let us denote this by T .
Disposable income then is Y T and aggregate consumption is ( ) C a b Y T = + .
Aggregate demand then is ( ) C I G a b Y T I G + + = + ( + +

.
Solving for equilibrium output we will get:
*
1 1 1 1
a b I G
Y T
b b b b
= + +

.

iii. Model 4b: Y = C + I + G (with proportional tax)
Proportional tax is . If t is the tax rate, tY is the proportion of income that is taken by the
government. Income available for consumption (or disposable income) is Y tY or
( ) 1 t Y . Consumption function changes into ( ) 1 C a b t Y = + .
If aggregate demand is ( ) 1 C I G a b t Y I G + + = + ( + +

, equilibrium output is
( ) ( ) ( )
*
1 1 1 1 1 1
a I G
Y
b t b t b t
= + +

.

c. The Multiplier Model
i. The expenditure multiplier
If investment changes, the amount of change in output is
1
1
Y I
b
=

.
If government spending changes, the amount of change in output is
1
1
Y G
b
=

.
Note that
1
1
1 b
>

. Thus, for every one peso increase in G or I, the corresponding increase in

. Decrease in taxes will increase output and an increase will decrease output.
The tax multiplier is less than the multiplier in absolute terms.
iii. Comparison of the expenditure multipliers of a lump-sum tax and of a proportional tax
Suppose that government spending (investment). If the government is imposing a lump-sum
tax, we expect that output will increase by
1
G
b

1
I
b
| |
|

\
. On the other hand, if the
government is imposing a proportional tax, we expect that output will increase by
( ) 1 1
G
b t

( ) 1 1
I
b t
| |

|
|

\
.
Now the question is Which of the two multipliers has greater impact on output?
Notice that the difference between the two multipliers is at the denominator. Particularly, the
marginal propensity to consume, b is multiplied by (1 t) for the proportional tax multiplier.
Since b and ( ) 1 t are between zero and one, then ( ) 1 b t b < . Multiplying 1 on both
sides and 1 will reverse the inequality: ( ) 1 1 1 b t b > . Thus,
( )
1 1
1 1 1 b t b
<

.
Therefore, a 1 peso increase in government spending or investment at lump-sum tax regime
has greater increase in output than that at proportional tax regime.