Explain the difference between the government purchases multiplier and the net tax multiplier. If the MPC falls, what happens to the tax multiplier?
Take a shot. What do you think is the difference. Hint: if government spending goes up by $100, then incomes immediately rise by $100. Then people spend some portion of this, and save the rest -- generating a multiplier effect. In the tax world, if taxes fall by $100, how much do people spend of this increase in disposable income?
The government purchases multiplier and the net tax multiplier are both concepts used in economics to understand the impact of changes in government spending or taxes on the overall economy.
The government purchases multiplier represents the effect of an increase in government purchases on the level of real GDP or national income. It measures how much an initial change in government spending will impact the overall output of the economy in the short run. It captures the idea that when the government increases its purchases, it stimulates demand and generates a multiplier effect, as individuals and businesses earn additional income and subsequently spend a portion of that income, leading to further economic activity.
On the other hand, the net tax multiplier represents the effect of changes in net taxes (taxes minus transfers) on the level of real GDP or national income. It measures the impact of changes in taxes on disposable income, which in turn affects consumption spending. When taxes are reduced, people have more disposable income to spend or save, which can lead to an increase in overall consumption and economic activity. The net tax multiplier captures the idea that changes in taxes have an effect on aggregate demand, as they directly influence individuals' ability to spend.
Now, if the MPC (Marginal Propensity to Consume) falls, it means that individuals tend to save a higher proportion of any increase in income rather than spend it. This decrease in the willingness to consume indicates a lower spending multiplier effect in response to changes in government purchases or net taxes.
In the case of the tax multiplier, if the MPC falls, it implies that people are more likely to save a larger portion of any increase in disposable income resulting from a tax cut. As a result, the net tax multiplier will decline because the change in disposable income will have a smaller impact on consumption. Essentially, a lower MPC leads to a lower spending multiplier effect and diminishes the overall impact of the tax cut on the economy.
Therefore, when the MPC falls, the tax multiplier decreases, and the effect of a tax change on overall economic activity becomes smaller.