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Balanced Budget Multiplier

The balanced-budget multiplier indicates the impact on aggregate production when government purchases and taxes change by the same amount. The government expenditure multiplier increases income by 1/1-MPC due to additional spending. The tax multiplier decreases income by -MPC/1-MPC due to less disposable income. However, when government spending and taxes both rise equally, the multipliers cancel out, resulting in a balanced-budget multiplier of 1 - meaning aggregate production does not change.

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Sreyashi Ghosh
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1K views5 pages

Balanced Budget Multiplier

The balanced-budget multiplier indicates the impact on aggregate production when government purchases and taxes change by the same amount. The government expenditure multiplier increases income by 1/1-MPC due to additional spending. The tax multiplier decreases income by -MPC/1-MPC due to less disposable income. However, when government spending and taxes both rise equally, the multipliers cancel out, resulting in a balanced-budget multiplier of 1 - meaning aggregate production does not change.

Uploaded by

Sreyashi Ghosh
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Balanced Budget Multiplier

 The balanced-budget multiplier indicates the overall impact on aggregate


production of a change in government purchases that is matched by an
equivalent change in taxes.

NOTE:

G - Government Expenditure
T - Taxes
C - Consumption
AD/AE - Aggregate Demand/Aggregate Expenditure
Y - Income

Let’s now consider Government Expenditure Multiplier & Tax Multiplier

Government Expenditure Multiplier

 The government spending multiplier is the same as the regular multiplier:


{Spending multiplier} = 1 / (1-MPC),
because G is a component of autonomous spending.
-- Ex.: If MPC = 0.9, then the government spending multiplier is 10 (= 1/ (1-0.9) = 1/0.1).
Tax Multiplier

The tax multiplier is said to be negative. Why is it so?

The reason goes like this: There exists an inverse relationship or negative correlation
between taxation and consumption spending.

A rise in taxes (+ve) causes a reduction in disposable income and therefore in


consumption spending (-ve).

A reduction in taxes (-ve) causes an increase in disposable income and therefore in


consumption spending (+ve).

Just as a change in government purchases has a multiplied effect on income, so does a


change in taxes.

As before, the initial change in expenditure, now MPC × ∆T, is multiplied by 1/ (1 −


MPC).The overall effect on income of the change in taxes is ∆Y/∆T = −MPC/ (1 − MPC).

This expression is the tax multiplier, the amount income changes in response to a
change in taxes.

{Tax multiplier} = - MPC / (1-MPC)

Balanced Budget Multiplier (BBM): Government Expenditure Multiplier & Tax


Multiplier taken together & Why BBM is equal to 1

 Q: What would happen if the government increased spending and taxes by equal
amounts, applying these multipliers?
-- (The result may surprise you. For most of us, our automatic response is to think that
would somehow be a bad thing for the level of GDP, since higher taxes plainly lower
our disposable incomes and leave less for our consumption. Or we might think that it
would have zero effect on GDP, because the higher spending and the higher taxes
would seem to offset each other. But, in the context of the multiplier model, both of
those guesses would be wrong. Instead....)

 A: An equal increase in G and T would actually raise GDP, in the context of the
multiplier model.

 Why: Recall that the government-spending multiplier is


{Spending multiplier} = 1 / (1-MPC) = 1/MPS … (I),
{Tax multiplier} = - MPC / (1-MPC) = -MPC/MPS …… (II)

Add the two together and you get the multiplier for an equal increase in government
spending and taxes.
Equivalently, it is the increase in equilibrium GDP that results from a $1 increase in G
and a $1 increase in T.
We call it the BALANCED-BUDGET MULTIPLIER (BBM; or perhaps more accurately the
tax-and-spend multiplier), and it is equal to the sum of those other two:

 From (I) and (II)


 (The term balanced-budget multiplier does not necessarily mean that the overall
budget is in balance, just that we're increasing G and T by equal amounts.)

Excerpts from a Book

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