If the ad shortfall is $600 billion and the mpc is 0.8,

P11-1
1. In the tax cut example on pages 236–37,
( a ) By how much does consumer saving increase initially?
( b ) How large is the initial spending injection?
This was the objective of the 2008 Bush tax cuts, which gave all taxpayers a rebate of
$300–600 in the summer of 2008. By putting $168 billion more after-tax income into the
hands of co n sumers, Congress hoped to stimulate (shift) the consumption component of
aggregate d e mand. President Obama used the tax cut tool as part of his 2009 stimulus package
and again in 2011.
Taxes and Consumption. A tax cut directly increases the disposable income of consumers.
The question here, however, is how a tax cut affects spending. By how much will
consumption increase for every dollar of tax cuts?
The answer lies in the marginal propensity to consume. Consumers won’t spend every
dollar of tax cuts; they’ll save some of the cut and spend the rest. The MPC tells us how the
tax cut dollar will be split between saving and spending. If the MPC is 0.75, consumers will
spend $0.75 out of every tax cut $1.00. In other words,
Initial increase in consumption 5 MPC 3 Tax cut
If taxes were cut by $200 billion, the resulting spree would amount to
Initial increase in consumption 5 0.75 3 $200 billion
5 $150 billion
Hence the effect of a tax cut that increases disposable incomes is to stimulate co nsumer
spending. A tax cut therefore shifts the aggregate demand curve to the right.
Multiplier Effects. The initial consumption spree induced by a tax cut starts the multiplier
process in motion. The new consumer spending creates additional income for producers
and workers, who will then use the additional income to increase their own consumption.
This will propel us along the multiplier path already depicted in Figure 11.4. The cumulative
change in total spending will be
Cumulative change
in spending 5 Multiplier 3
Initial change
in consumption
In this case, the cumulative change is
Cumulative change
in spending 5
1
1 2 MPC
3 $150 billion
5 4 3 $150 billion
5 $600 billion
Here again we see that the multiplier increases the impact on aggregate demand of a fiscal
policy stimulus. There’s an important difference here, though. When we increased gover nment
spending by $200 billion, aggregate demand increased by $800 billion. When we cut
taxes by $200 billion, however, aggregate demand increases by only $600 billion. Hence a
tax cut contains less fiscal stimulus than an increase in government spending of the
same size.
The lesser stimulative power of tax cuts is explained by consumer saving. Only part of a
tax cut gets spent. Consumers save the rest. This is evident in Figure 11.5, which illustrates
the successive rounds of the multiplier process. Notice that the tax cut is used to increase
both consumption and saving, according to the MPC. Only that part of the tax cut that’s
used for consumption enters the circular flow as a spending injection. Hence the initial
spending injection is less than the size of the tax cuts. By contrast, every dollar of government
pu r chases goes directly into the circular flow. Accordingly, tax cuts are less powerful
than go v ernment purchases because the initial spending injection is smaller.
This doesn’t mean we can’t close the AD shortfall with a tax cut. It simply means that
the desired tax cut must be larger than the required stimulus. It remains true that
Desired fiscal stimulus 5
AD shortfall
Multiplier
The Fiscal Policy Tool
CHAPTER 11: FISCAL POLICY 237
But now we’re using a consumption shift as the fiscal stimulus rather than increased go vernment
spending. Hence we have to allow for the fact that the initial surge in consumption
(the fiscal stimulus) will be less than the tax cut. Specifically,
Initial consumption injection 5 MPC 3 Tax cut
If we want to use a consumer tax cut to close a GDP gap, we have
Desired tax cut 5
Desired fiscal stimulus
MPC
In the economy in Figure 11.3, we assumed that the desired stimulus is $200 billion and the
MPC equals 0.75. Hence the desired tax cut is
Desired tax cut 5
$200 billion
0.75
5 $267 billion
By cutting taxes $267 billion, we directly increase disposable income by the same
amount. Consumers then increase their rate of spending by $200 billion (0.75 3 $267 bi llion);
they save the remaining $67 billion. As the added spending enters the circular flow,
it starts the multiplier process, ultimately increasing aggregate demand by $800 billion
per year.
This comparison of government purchases and tax cuts clearly reveals their respective
power. What we’ve demonstrated is that a dollar of tax cuts is less stimulative than a dollar
of government purchases. This doesn’t mean that tax cuts are undesirable, just that they
need to be larger than the desired injection of spending. The following News shows that the
2008 tax cut boosted consumer spending by 3.5 percent, thereby shifting AD to the right
and accelerating real GDP growth.
P11-2
2. Suppose the consumption function is
C 5 $400 billion 1 0.8Y
and the government wants to stimulate the economy. By how much will aggregate demand at
current prices shift initially (before multiplier effects) with
( a ) A $50 billion increase in government purchases?
( b ) A $50 billion tax cut?
( c ) A $50 billion increase in income transfers?
What will the cumulative AD shift be for
( d ) The increased G?
( e ) The tax cut?
( f ) The increased transfers?
P11-3
3. Suppose the government decides to increase taxes by $20 billion to increase Social Security
benefits by the same amount. How will this combined tax transfer policy affect aggregate
demand at current prices?
P11-5
5. If the AD shortfall is $600 billion and the MPC is 0.9,
( a ) How large is the desired fiscal stimulus?
( b ) How large an income tax cut is needed?
( c ) Alternatively, how much more government spending would achieve the target?
P11-6
6. If the AD excess is $300 billion and the MPC is 0.8,
( a ) How much fiscal restraint is desired?
( b ) By how much do income taxes have to be increased to get that restraint?
P11-7
7. ( a ) According to the News on page 238, how much more did the average household spend on
appliances, electronics, and furniture when it received the 2008 tax r e bate?
(b) If all 110 million households did so, how much did aggregate consumption i n crease?
( c ) If the MPC was 0.75, how much would cumulative spending increase as a r e sult?
I N T H E N E W S
Just How Stimulating Are
Those Checks?
To get an idea of how much those government rebate
checks have spurred spending—and who’s benefiting
from the buying—business school professors Jonathan
Parker (Northwes t ern) and Christian Broda (University
of Chicago) analyzed the spending of 30,000 rebatereceiving
households. Using data provided by ACNielsen’s
Homescan, whose participants scan the
barcodes on their purchases into a database, the
researchers found the rebates “clearly have increased
household spending,” Parker says. Lower-income
households boosted consumption most—spending 6
percent more, compared with a 3.5 percent rise across
all households.
—Tara Kalwarski
THE 2008 REBATE BOOST
Additional dollars spent due to
stimulus checks*
Clothing, shoes, and
accessories $32
Food, health, beauty, and
household products $60
Entertainment and personal
services $87
Appliances, electronics,
and furniture $91
Source: BusinessWeek, September 8, 2008, p. 14. Used with
permission of Bloomberg L.P. Copyright © 2011. All rights
reserved.
Analysis: The 2008 tax cuts were a form of fiscal stimulus that boosted consumption
(personal spending), increased real GDP growth, and reduced unemployment.