Taxes
Putting these three together, therefore, we see that an increase in GDP of $100 causes consumption to increase by $57. The marginal propensity to spend in this economy was equal to about 57 percent. It follows that the CEA thought that the multiplier was equal to about 2.3 because
multiplier = 1
1 – marginal propensity to spend
= 1
1−0.57
= 1
0.43
= 2.3.
Now let us think about the change in autonomous spending. We have said that taxes were cut by about $10 billion. We expect that most of this tax cut ended up in the hands of consumers. Based on the marginal propensity to consume of 0.93, we would therefore expect there to be an increase of about $9.3 billion in autonomous consumption, change in autonomous spending = $9.3 billion. Putting these two results together, we find that our prediction for the change in GDP as a result of the tax cut is change in real GDP = multiplier × change in autonomous spending = 2.3 × $9.3 billion = $21.4 billion. Our answer is not exactly equal to the $20 billion predicted by the CEA, but it is very close. As you might expect, the CEA was working with a more complicated model than the one we have explained here, and, as a result, they came up with a slightly smaller number for the multiplier. A Word of Warning All our analysis so far has ignored the fact that, through the price adjustment equation, increased real GDP causes the price level to rise. This increase in prices serves to choke off some of the effects of the increase in spending. In effect, we have ignored the supply side of the economy. It is not that the Kennedy-Johnson administration economists were naïve about the supply side, but they thought the demand side movements were much more relevant for short-run policymaking purposes. More recent economic experience has convinced economists that we ignore the supply side of the economy at our peril. Modern macroeconomists would be careful to augment this story with a discussion of price adjustment. Toolkit: Section 16.20 “Price Adjustment” You can review price adjustment in the toolkit.
