Sunday, March 8, 2009

Money Multiplier Effect Sample

For example: a company spends $1 million to build a factory. The money does not disappear, but rather becomes wages to builders, revenue to suppliers etc. The builders will have higher disposable income as a result, so consumption, hence aggregate demand will rise as well. Suppose further all of the recipients of new factory spending in turn spend it. The increase in the gross domestic product is the sum of the increases in net income of everyone affected. If the builder receives $1 million and pays out $800,000 to sub contractors, he has a net income of $200,000 and a corresponding increase in disposable income (the amount remaining after taxes). This process proceeds down the line through subcontractors and their employees, each experiencing an increase in disposable income to the degree the new work they perform does not displace other work they are already performing. Each participant who experiences an increase in disposable income then spends some portion of it on final (consumer) goods, according to his or her marginal propensity to consume, which causes the cycle to repeat an arbitrary number of times, limited only by the spare capacity available. Another example: when a tourists visit somewhere they need to buy the plane ticket, catch a taxi from the airport to the hotel, book in at the hotel, eat at the restaurant and go to the movies or tourist destination. The taxi driver needs petrol (gasoline) for his cab, the hotel needs to hire the staff, the restaurant needs attendants and chefs, and the movies and tourist destinations need staff and cleaners. In congressional testimony given in July 2008, Mark Zandi, chief economist for Moody's, provided estimates of the one year multiplier effect for several fiscal policy options. The multipliers showed that increased government spending would have more of a multiplier effect that tax cuts. The most effective policy, a temporary increase in food stamps, had an estimated multiplier of 1.73. Making the Bush tax cuts permanent, had the second lowest multiplier, 0.23. A payroll tax holiday had the largest multiplier for tax cuts, 1.29. Refundable lump-sum tax rebates, the policy used in the Economic Stimulus Act of 2008, had the second largest multiplier for a tax cut, 1.26.[3] Estimation has found "textbook" values of multipliers are overstated. The following tables has assumptions about monetary policy along the left hand side. Along the top is whether the multiplier value is for a change in government spending (ΔG) or a tax cut (-ΔT). Monetary Policy Assumption ΔY/ΔG ΔY/(-ΔT) Interest Rate Constant 1.93 1.19 Money Supply Constant 0.6 0.26

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