Impact of Balanced Budget Multiplier on GDP: Explanation and Limitations
In a closed economy, the balanced budget multiplier is a crucial concept that measures the change in aggregate output (GDP) when government spending and taxes change by the same amount, keeping the budget balanced. This multiplier, approximately equal to 1, indicates that a $1 increase in government spending financed entirely by a $1 increase in taxes leads to about a $1 increase in total economic output.
The marginal propensity to consume (MPC) refers to the portion of additional disposable income allocated to the consumption of goods and services. In this context, an MPC of 0.8 means that for every additional dollar of disposable income, households will spend 80 cents and save the remaining 20 cents. As a result, an increase in tax will lead to a decrease in consumption of $80.
Government spending has a more significant impact on economic activity than tax changes. This is due to several reasons:
- Government spending directly injects dollars into the economy, immediately increasing aggregate demand.
- Tax changes indirectly affect demand by changing disposable income. However, consumers typically save part of the tax cut (MPC < 1), so the stimulus effect is smaller. Conversely, a tax increase reduces consumption by only a fraction of the tax amount.
- Empirical studies show that government spending multipliers tend to be larger than tax multipliers, especially when balanced-budget rules force tax increases to offset spending changes, which can dampen the net effect.
To illustrate, let's consider a scenario where the government increases spending by $100. This raises output by approximately $100 directly. Simultaneously, the increase in tax will lower consumption by less than $100 (since MPC < 1), so the overall effect on output is smaller. However, the net effect is still an increase in aggregate demand by $20 (Rp100 - $80).
It's important to note that the balanced budget multiplier remains near unity due to offsetting fiscal actions. This means that while government spending and taxes change, the overall impact on the economy is relatively modest.
In summary, in a closed economy:
- $1 Government Spending raises output by approximately $1 directly.
- $1 Taxes lower consumption by less than $1 (since MPC < 1), so the effect on output is smaller.
- A balanced budget change ($1 increase in spending and taxes) results in a net effect of ~ $1 increase in output (balanced budget multiplier ≈ 1).
Thus, government spending changes have more potent immediate effects on economic activity than equivalent tax changes, though the balanced budget multiplier remains near unity due to offsetting fiscal actions.
Investing in government business can drive economic growth, as each dollar spent by the government directly raises output by a similar amount due to the immediate injection of dollars into the economy. On the other hand, an increase in taxes can lead to a decrease in consumption by less than the tax amount, given the marginal propensity to consume is less than one. Consequently, government investing has a more significant impact on economic activity compared to tax changes.
