Question

7. Which type of discretionary fiscal policy is likely to have the smallest overall effect on GDP because of the low MPC related to the policy?

Answer 1

Tax multipliers are based on the population's willingness to consume. The marginal propensity to consume, or MPC, is a measure of that willingness. It is defined as the amount of an additional dollar of income that a consumer will spend on goods and services. The MPC can have a value between 0 and 1. A small MPC represents a large amount of savings and a small amount of consumption. A large MPC represents a small amount of savings and a large amount of consumption. When a tax decrease occurs, consumers will spend part of the money and save part of it. Therefore, the actual change in national income as a result of a change in tax policy is equal to [(+ or -) change in taxes * - MPC] / (1 - MPC). The resulting number is called the tax multiplier.

There is also a multiplier for government spending. This multiplier is derived in a different way. When the government increases purchases, it directly increases output, or national income. But, there is a greater effect than just the actual amount of increase in government purchases. When the government spends more, the populace receives more. That is, because the population is the target of increased government spending, personal incomes, and thus consumption, increases. Once again, the size of this increase is based on the MPC. The total change in output as a result of a change in government purchases is equal to (change in government purchases) / (1 - MPC). This number is called the government spending multiplier. So contractionary fiscal policy is likely to have smallest change in GDP because of low MPC.