Congress is considering a tax credit program for those who purchase energy-effic
ID: 1248380 • Letter: C
Question
Congress is considering a tax credit program for those who purchase energy-efficient appliances. Proponents of the program have said that $400 million will be given directly to taxpayers and argue that this will have an economic effect that is greater than the original $400 million spent because of the multiplier effect. Many voters and taxpayers are not familiar with the concept of a multiplier in this sense. Your think tank has decided to produce a short report that will help voters better understand the proponents’ claims, and Gabe has asked you to write this report.Be sure to include the following in your report:
* Give a basic explanation of how the multiplier concept is computed, including MPC.
* Assume that the average American’s marginal propensity to consume (MPC) is 2/5, and American producers’ MPC is also 2/5.
* Calculate the following, explaining how you arrived at each result:
o The amount consumers will spend on new consumption
o The amount of new spending from producers
o The multiplier in this case
o The total increase in spending from the primary spending of $400 million
* Explain the multiplier concept as it applies in this case.
* What are the qualifications and limitations of the multiplier model?
Explanation / Answer
The measures adopted by the Federal Government to stimulate the economy when there is recession or fall in aggregate demand are:
1) By Increasing Government Spending.
2) By Tax reduction.
3) A combination of the above two options.
Increase Government Spending:
By increasing the Government spending the aggregate demand curve will shift towards its right. Suppose that the Government wants to spend a $5 billion on building roads, health care etc. if the marginal propensity to consume (MPC) is 0.5, than a $10 billion spent will increase the consumption or aggregate demand by $ 20 billions. (For MPC 0.5, the multiplier is 2, so 2 times of $10 billions is $20 billions.)
Tax reduction:
By reducing the tax:
Suppose the Federal government plans to reduce the taxes by $10 millions. So there will be excess money (disposable income) available to the people. This excess amount at an MPC of 0.8, there will be a saving of $2million and consumption of $8 million. And the real GDP or consumption rises by 5 times of $8 million, i.e, $40 millions, resulting in a shift in the aggregate demand curve to its right.
So, by these measures government will stimulate the economy.
MPC (Marginal Propensity to Consume):
MPC is the slope of consumption curve with respect to a change in the disposable income.
It gives a consumption pattern of an economy, i.e it gives out of the total income earned by a household, how much a household will be spending.
MPC is a ratio of change in consumption with change in income.
MPC= Change in consumption/ Change in income.
When MPC= 2/5 = 0.4
Which means every dollar earned by an US national, $0.4 is spent and $0.6 is saved.
If MPC= 0.8.
80% i.e, $0.8 is spent and 20%, $0.20is saved.
Multiplier: Change in GDP/ Initial change in income.
Alternatively, multiplier can also be calculated by MPC.
Multiplier= 1/1-MPC
At 0.4 MPC, multiplier is
Multiplier= 1/1-0.4
= 1/0.6
= 1.67
It implies, an initial change in income by $1 makes the GDP change by 1.67 times x $1, i.e $1.67.
Multiplier Effect and MPC:
In the above cases when government spends $400 millions or gives away tax credit of $400 millions, there will be an increases in the disposable income of the people. The disposable income thus earned will be increase the aggregate demand by several times more than the actual rise in income levels; this is due to multiplier effect.
This multiplier effect is due to two reasons.
1) The economy provides repetitive and continuous flow of income and subsequent spending as a continuous chain of process.
2) Change in this income, more appropriately disposable income, gives spending and saving pattern change in the same direction.
Assume that the average American’s marginal propensity to consume (MPC) is 2/5, and American producers’ MPC is also 2/5.
•Calculate the following, explaining how you arrived at each result:
The amount consumers will spend on new consumption
The amount of new spending from producers
When MPC= 2/5
=0.4
Multiplier= 1/1-MPC
At 0.4 MPC, multiplier is
Multiplier= 1/1-0.4
= 1/0.6
= 1.67
The consumers or producers will spend 40% of their income and save the rest.
The amount consumers will spend on new consumption: due to multiplier effect.
Consumers include total American consumers. Here by this $400 million tax credit. There is an initial increase in income in the economy by $400 millions.
So, the aggregate additional spending by consumers due to this increase in income is given by multiplying the multiplier with initial change in income.
So, Change in Aggregate spending= 1.67 x $400 millions.
= $ 668 millions.
This $ 668 includes domestic and investment consumption.
The amount of new spending from producers:
Here the initial amount to the producer is $400 million, in the form of tax credit.
Out of this, as the MPC is 0.4.
The initial spending by producers will be 40%
Initial spending= 40% of 400
= 160 millions
Let us assume, Mr. Abraham, purchases a solar powered product and earns a tax credit of $400 millions, Mr. Abraham’s disposable income rises by $400 millions.
Now let us assume that the MPC (Marginal Propensity to Consume) of US is 2/5or 0.4. This means every dollar earned by the US citizen, 40 % is spent or consumed, or as per the definition, 40% of the income is expended and 60% is saved. So, out of $400millions, $160 millions is spent or consumed for different purposes like, purchasing a new car, transportation, food, movies, charity etc. Here he had spent $160 millions, and in the next level, let us assume that his cooks salary is $10million/ annum, i.e., he gets $10 millions out of the $ 160 millions of Mr. Abraham, and he too spends in the same fashion, $5millions he spends and saves $5millions, since the spending pattern will not change as discussed above in the second reason, and this process continues like a chain and magnifies making a shift in the GDP. This is called multiplier effect.
Multiplier= Change in real GDP/ Initial change in spending.
Alternatively we can also find the multiplier from the MPC,
Multiplier= 1/ (1-MPC)
Let us calculate the multiplier and the change in GDP.
At MPC= 2/5
Multiplier= 1/1-MPC
At 0.4 MPC, multiplier is
Multiplier= 1/1-0.4
= 1/0.6
= 1.67
So, GDP change is
Change in GDP= multiplier X Initial change in spending
=1.67 x 400
=$ 668 millions.
Hence by increasing $400 millions of disposable income, in the way of taxes, it had given a total spending of $668 millions in the economy.
What are the qualifications and limitations of the Multiplier Model?
Qualifications:
The Multiplier model is proposed by Keynes.
This multiplier effect is due to two reasons.
1) The economy provides repetitive and continuous flow of income and subsequent spending as a continuous chain of process.
2) Change in this income, more appropriately disposable income, gives spending and saving pattern change in the same direction.
Limitations:
It is for a closed economy and static.
It does not include the social factors like speculations, for example, a speculation on future Policy reversals:
If people speculate that the current reduction in taxes may get reversed in the near future, they tend to save more to meet the future expenses rather that to spend, so this does not change the spending pattern, causing ineffective on the aggregate demand.
Multiplier assumes a constant spending patterns, and MPC is calculated by the past consumption behavior of the economy. This assumption of constant pattern may change during course of time.