Explain why a $500 million increase in government purchases of goods and services will generate a larger rise in real GDP than a $500 million increase in government transfers.
A $500 million increase in government purchases of goods and services directly increases aggregate spending by $500 million, which then starts the spending multiplier in motion. It will increase real GDP by $500 million × 1/(1 − MPC ). A $500 million increase in government transfers increases aggregate spending only to the extent that it leads to an increase in consumer spending. Consumer spending rises by MPC × $1 for every $1 increase in disposable income, where MPC is less than 1. Thus, a $500 million increase in government transfers will cause a rise in real GDP only MPC times as much as a $500 million increase in government purchases of goods and services. It will increase real GDP by $500 million × MPC /(1 − MPC ).
Question
Explain why the tax multiplier is smaller than the spending multiplier for a decrease in government purchases.
The tax multiplier is relatively small because the initial change in spending is relatively small. For each $1 increase in taxes, the initial decrease in spending is only the MPC , whereas a $1 decrease in government purchases decreases spending by a full $1.
Question
The country of Boldovia has no unemployment insurance benefits and a tax system that uses only lump-sum taxes. The neighboring country of Moldovia has generous unemployment benefits and a tax system in which residents must pay a percentage of their income. Which country will experience greater variation in real GDP in response to demand shocks, positive and negative? Explain.
Boldovia will experience greater variation in its real GDP than Moldovia because Moldovia has automatic stabilizers while Boldovia does not. In Moldovia, the effects of slumps will be lessened by unemployment insurance benefits, which will support residents’ incomes, while the effects of booms will be diminished because tax revenues will go up. In contrast, incomes will not be supported in Boldovia during slumps because there is no unemployment insurance. In addition, because Boldovia has lump-sum taxes, its booms will not be diminished by increases in tax revenue.