Question 10 of 15intermediate🔍 AnalyzeLong Answer4 marks

Explain why the tax multiplier is smaller in absolute value than the government expenditure multiplier.

Correct Answer

The government expenditure multiplier is given by 11−c\frac{1}{1-c} whereas the tax multiplier is given by −c1−c\frac{-c}{1-c}. The tax multiplier is smaller in absolute value than the government expenditure multiplier because of the difference in how they impact total spending.

An increase in government expenditure affects total spending directly. When the government spends more, it immediately adds to the aggregate demand, initiating the multiplier process with the full force of the initial injection.

In contrast, taxes enter the multiplier process through their impact on disposable income. When taxes are cut, disposable income rises, but households only spend a portion of this increase determined by the marginal propensity to consume. Thus, with a reduction in taxes, consumption and total spending increase in the first instance only by cΔTc\Delta T, which is a fraction of the tax change.

For example, if the marginal propensity to consume is 0.8, the government expenditure multiplier is 5, while the tax multiplier is -4. The tax multiplier is always one less in absolute value than the government expenditure multiplier.

Exercise: EXERCISES | Q: 10 | (Page 19)
For More Understanding

Explanation

The answer is derived from the comparison provided in the textbook context. It highlights that government spending is a direct component of aggregate demand, whereas taxes affect demand indirectly via disposable income and consumption (MPC). The numerical example (MPC=0.8) from the text is used to illustrate that the multiplier values are 5 and -4 respectively, confirming the relationship.

Solution Steps

  1. Step 1: Identify the formulas from the context: Government expenditure multiplier = 1/(1-c) and Tax multiplier = -c/(1-c).

  2. Step 2: Explain the mechanism: Government spending affects total spending directly, while taxes affect disposable income first, leading to a smaller initial injection (c times the tax change).

  3. Step 3: Verify with the provided example: With MPC (c) = 0.8, Govt Multiplier = 5 and Tax Multiplier = -4.

  4. Step 4: Conclude that the absolute value of the tax multiplier (4) is one less than the government expenditure multiplier (5).

PreviousNext