UT

MSF - DALLAS
MACROECONOMICS
Summer 2020
Homework 1 (with answers)

Please complete neatly and professionally. These questions are based on the Fiscal Policy Self-
Study Module. You are free to use this Word Document as you see fit to submit your answers.
But when you submit, please first convert to PDF and then upload using the portal on Canvas.
Other file formats have caused difficulty in the past.

Due via PDF upload: Monday, July 20, 8am.

This homework addresses the material from the Fiscal Policy Self Study Module.

1. What is the simple fiscal multiplier? What exactly does it tell us?

The simple fiscal multiplier tells us the change (increase or decrease) in AD for a
given change in government spending, G. Specifically, government purchases, as
they are defined in GDP. The “simple” just means that we are assuming that none
of the factors that mitigate the multiplier are present, for ease of explanation.
The simple fiscal multiplier is multiplied by the change in G to get the change in
AD. But this estimate will be too large, normally, due to the presence of what I
called, “mitigating factors” that reduce its value. See the discussion beginning on
pages 8 – 10 up to the mitigating factors section. But, the fiscal multiplier is the
first step in assessing the effectiveness of monetary policy (how much did overall
spending, or AD, change as a result of the policy?).

2. What determines the magnitude of the simple fiscal multiplier?

The primary determinant of the magnitude of the simple fiscal multiplier is
the marginal propensity to consume, or MPC.
• The MPC is the change in household consumption when disposable income
(income net of taxes) changes. That is a little more precise than what I
wrote in the self-study module, where is just says household income.
§ For example, if household disposable income increases by $1, the
MPC tells by how many cents consumption will increase, the
remainder going to household savings.
§ Clearly, this is different for different households.
• For example, lower-income households will have a higher
MPC than rich households. When disposable income
increases for poorer households, they tend to spend all or
most of it, since they normally don’t have all they need to
purchase everything they may want.
 • Higher income households don’t have that problem, and
when their disposable income increases (unexpectedly, say),
they don’t spend it. It just adds to their wealth as savings.
(What do you think Warren Buffet would do if he got a
$1,200 relief check in the mail? Go buy that new bike he
always wanted?)
• Older households have lower MPC, because they live on
“fixed incomes.” Most retired households will never receive
another paycheck, so they are more frugal and save much of
any unexpected increase in disposable income.
§ The MPC for the entire economy is the average of the MPCs for the
households that comprise the economy.
§ As a general rule, the fiscal multiplier and its close cousin the tax
multiplier (simple version or otherwise) are greater in magnitude,
the greater the MPC, since more of the increase in G or tax cut will
be spent and therefore contribute to an increase in AD.
• And for tax cuts targeted at certain segments of the
population, the more that the tax cut is targeted toward low-
income households, the more effective it will be at
stimulating AD for the overall economy.

3. Why is the simple tax multiplier less than the simple fiscal multiplier?

The simple tax multiplier is similar to the simple fiscal multiplier, but it tells
us by how much AD will change for a given change in taxation by the federal,
state and local governments. It has the opposite sign from the spending
multiplier, because increases in G or decreases in taxes, T both work to
increase AD (and the opposite is also true, of course).

It is less than the simple fiscal multiplier for the simple reason that the simple
fiscal multiplier addresses changes in G, which is included in the definition of
AD (which is really the same thing as nominal GDP, PY, from the Phillips Curve
slides). So, when G increases or decreases, AD goes up and down with it. Then,
multiplier effects increase or decrease it further.

Taxes, on the other hand, are not a component of nominal GDP. It includes
household consumption, investment, government spending, and net exports,
recall. No taxes there. Instead, tax changes will affect C and or I. Our focus
with the multipliers is changes in C. So, if taxes decrease (a “tax cut”), C will
increase and so will AD. But it doesn’t fall by the full amount of the tax cut,
because households consume only MPC times the tax cut and save the rest.
Anything saved does not contribute to AD in the “here and now,” which is
presumably why taxes were cut in the first place.

 4. What is crowding out? How does it reduce the multiplier effects of an increase in
government spending or a tax cut?

Empirically, the presence of crowding out would mean that there is a positive
relationship between government deficits and debt and interest rates in the
economy. Why would that occur? When the federal government deficit
increases (increases in G or decreases in T), it must borrow the money by
issuing new debt. That debt is sold into capital markets to investors that were
already holding and perhaps actively trading Treasury securities and other
capital market assets. This may cause interest rates to rise, as the new debt
competes with the assets already in circulation. If investors are going to buy
this new debt and then lend money to the government, they may have to be
incentivized with higher interest rates, which the market may provide.

Why all the hedging in my answer? I used the word, “may.” Because although
crowding out may have been a relevant phenomenon in markets in the past, it
does not appear to be active in the current economy, nor has it for decades.
Right now, even before the pandemic, our deficit is quite high (especially for a
non-crisis period) as a percentage of GDP. And federal government debt as a
fraction of GDP has only been higher during WWII and the aftermath of the
Revolutionary War. Yet interest rates are at record lows. Crowding out is
clearly not an issue in our current economy.

5. What is Ricardian Equivalence? How does it reduce the multiplier effects of a tax
cut?

Ricardian Equivalence is a theory that implies that fiscal policy will have little
or no effect on AD, because any increases in household disposable income that
were due to government spending increase or tax cuts that increase
government debt will just be saved. So, for example, according to Ricardian
Equivalence, if the federal government cuts taxes, the deficit increases and
they must then issue more government debt, people will just save the tax cut
to pay the tax increases that must come someday to pay off the debt.

There is no doubt that some of every tax cut will be saved by at least some
households. And how much is saved is certainly of interest to economists and
policymakers that are attempting to design policies that stimulate AD. But
Ricardian Equivalence says that everyone saves the whole thing, meaning the
tax multiplier would be zero – no effect on AD at all! Again, there is substantial
evidence that this is not true.

6. If the federal government attempts to stimulate AD in the economy using a tax cut,
what segment of the population should the tax cut be targeted in order to magnify
its effect on AD?

 I forgot this question was here and answered it under number 2 above. If the
government wants the maximum effect on AD from a tax cut, then it should
target those with a high MPC, because they will consume most of the tax cut
and their spending increases AD. That means lower-income households.

I’m sure that you are aware that this is not what we did last tax cut. It was
targeted primarily at corporations and higher-income households. The
administration sold it as a plan to increase business investment by changing
the corporate tax code. And it did have some effect, but it was not substantial
and only lasted a couple of quarters. Overall, the tax cut had little effect on AD,
which many economists predicted base on its design.

7. With the past tax cut plans passed during both the Bush and Trump administration,
tax cuts were targeted toward higher-income people, and to avoid Congressional
rules regarding the effect on the deficit that would have involved a 2/3 majority to
pass the plans, they structured the tax cuts to expire once their administration is
over (then the next administration gets blamed for increasing taxes). What is the
impact on AD of making the tax cuts temporary?

Here is where I get to introduce the concept of permanent income, which is due
to Milton Friedman as is one of the areas in which his work won him the Nobel
Prize in economics. Friedman said that household disposable income
essentially has two components: permanent income and transitory income.
• Permanent income is the predictable part of your income. For most
people, this is just labor income, and Friedman defined permanent
income as the present discounted value of future expected labor income
(disposable, so with taxes netted out).
• Transitory income is unexpected. Maybe you got an unexpected bonus.
You win the lottery or receive an inheritance from an uncle you never
knew existed. Or … you get a tax cut because Congress decided to pass
one.
Friedman’s Permanent Income Hypothesis says that household consumption
depends on permanent income, not transitory income, which is typically saved.
So, if permanent disposable income increases/decreases, then household
consumption increases/decreases.
• If you take not of Friedman’s definition of permanent income as the
present discounted value of future expected disposable income, then it
is not hard to see that at temporary tax cut will have less of an effect
than a permanent tax cut. A permanent tax cut will have more of an
impact on permanent disposable income than a temporary tax cut.