1. State and explain the difference between two fiscal multipliers tax cut and increase in government expenditure in a closed economy.Ans. Fiscal Policy - The federal governments power to levy taxes and decide how that revenue is spent, and even borrow money all affects the aggregate demand curve and therefore macroeconomic outcomes: prices, output, and employment. The government can increase or decrease the aggregate demand curve by: increasing or decreasing its purchases of goods and services cutting or raising taxes raising or cutting transfer payments (social security, welfare, unemployment benefits)

When Congress and the President use purchases, taxes or transfers to affect macroeconomic outcomes, this is known asfiscal policy.DIFFERENCE BETWEEN TAX CUT AND INCREASE IN GOVERNMENT EXPENDITURE IN A CLOSED ECONOMY:One way to describe the economy is with the equationwhererepresents total income,represents consumption, andrepresents investment (other than government investment, of course)GEM - Government expenditure multiplierThe GEM considers the idea that since only a percentage of money that anyone receives is saved, and the rest is put back into the economy. So if the government gives someone a dollar (deficit spending), it will end up meaning that much more than a dollar will be added to the economy. One way to think about it is the GEM is the amount that, total income, changes as, government expenditure changes. So we look at our formula with the consumption function included, we have:

, which, in fact, gives,

TCM - Tax Cut MultiplierIn this case, we want to know how much a change in the tax rate will affect total income. Our derivation follows the same lines as before. In this case we have:

, which gives,

In general,since:.Suppose the economy is at an equilibrium that is below full employment output:The government can attempt to shift the AD curve to the right, increasing output, employment, and prices by either (1) cutting taxes or (2) increasing spending.

Increasing Government SpendingTotal increase in AD = multiplier x initial increase in spending where the multiplier = 1/(1-MPC)So in deciding how much to increase spending, the government needs to take the multiplier effect into account. If the MPC = .8, then the multiplier = 1/(1-.8) = 5. If the government wishes to increase the AD curve by $200 billion, and the MPC = .8, thenThe increase in spending = increase in AD/multiplier = $200 billion / 5 = $40 billion.If the government increases spending by $40 billion, the AD curve will shift $200 billion to the right.

Cutting TaxesA tax cut increases disposable income, which in turn increases consumer spending, which has a multiplier effect throughout the economy. However if the MPC is less than 1 then some of the tax cut is spent, and some of the tax cut is saved.Consider a $40 billion tax cut and an MPC of .8. The initial increase in consumption will be$40 billion x .8 = $32 billion.The total increase in AD will be$32 billion x 5 = $160 billion.Recall that a $40 billion increase in spending increased AD by $200 billion.Thus a tax cut is less powerful than a spending increase of the same size.So if the government desires a $200 billion increase in AD, the tax cut must be greater than $40 billion.Tax cut = [increase in AD x (1 - MPC)] / MPC = ($200 billion x .2) / .8 = $50 billion.Cutting taxes by $50 billion will increase AD by $200 billion.Transfers are like a negative tax, so an increase in transfer payments would work the same way as a tax cut, by increasing disposable income.The government can raise total spending either by buying more stuff, or it can lower taxes and hope that consumers take their tax breaks to the mall. Tax cuts stimulate both aggregate demand and aggregate supply. If taxes are temporarily lower, they make working today more attractive than working tomorrow, and thus increase labor supply. This boost to the nations productive capacity means that a tax-cut-based stimulus doesnt do as much to narrow the gap between output and what we can produce. The govt. spending multiplier is difference from the tax multiplier because the govt. spending total effect ripples off. That is if govt. spending increase then the total income increases. When total income increase, consumption increases, when consumption increases total income increases further and this pattern carried forward. This is the multiplier effect, such that an increase in govt. spending final impact on income is much bigger than its initial increase. The tax multiplier on the other hand has a much smaller effect than govt. spending. This is because tax is only a portion of the consumer income if there is a tax cut, consumers only save a fractional amount (specifically 1-mpc) of a tax cut. As a result tax cut is much less than an increase in govt. spending. Spending multiplier is positive number as an increase in equilibrium GDP. Tax multiplier is negative number. It is clear that to increase income and employment, money must be spent. One of the most important issues that beginning economics student have to learn is that income equals expenditures. Nobody can spend a penny without someone earning it, and no one can earn a penny without someone spending it. You may believe that our city, state, or federal government should spend less, and at times you might be right; but what you must realize is that any dollar not spent is a dollar not earned. Whether that money is spend on street repairs, renovating dilapidated school buildings, or hiring more teachers, it does increase income and employment. And it does not stop there; there is what economists call the multiplier effect. The formerly unemployed who now have an income will pay some of it in taxes, may save some of it and will spend the rest. What they spend will become income to someone else, who again will spend part of it and so increase further income. So how about tax cuts? Tax cuts do not accomplish the same, because the recipients of these tax cuts may not spend the money; and the larger the taxpayers income and wealth, the lower is what economists call the marginal propensity to consume, that part of any additional income that is spent. Suppose you are financially relatively well off, your house is paid for, you have nice savings, and the annual income for you and your spouse is $1,350,000. Now you get the $800 provided for in our current stimulus package for most taxpayers. By how much will you increase your expenditures? I would say that you probably would not buy anything that you would not have bought anyhow. But give $800 to a poor couple who doesnt have money to buy enough food and also heat their small apartment adequately, and who may not earn enough to pay taxes anyhow. You bet theyll spend it all immediately. But how about investments? Would higher income earner not spend money on investments? Lets suppose, then, that you are a manufacturer who produces ladies dresses and accessories, and because of our current recession your sales have dropped to half and you had to lay off some of your employees. Now you get a $20,000 tax cut. Will you now hire your laid-off workers again if you cant sell the things you have on hand? Hardly. You may use the money to pay back a loan you owe to your bank. Banks like to lend out money; after all their income comes from the interest paid on loans. But they will not lend out money these days to people, businesses or institutions that may not be able to repay the loans. So the money you paid to the bank will stay there, it has changed hands only once and the multiplier will is one. A super conservative, on the other hand, might argue that the government has no business interfering in the economy like that, with huge, uncalled for, unnecessary expenditures because, in the long run, the free market itself, if left alone, will take care of matters by itself. Keynes had an answer to that one also: In the long run, he wrote, well all be dead.