MACHAKOS UNIVERSITY
SCHOOL OF BUSINESS AND ECONOMICS.
DEPARTMENT OF ECONOMICS.
UNIT CODE: EET 301
UNIT NAME: MACROECONOMIC THEORY III
WRITTEN BY: DOROTHY NGINA KIMOLO
EET 301: Dorothy Kimolo@2021 Page 1 of 11
LECTURE THREE: INTRODUCTION TO EQUILIBRIUM INCOME
DETERMINATION: THE MULTIPLIER
3.1: Introduction
In this lecture we will discuss the derivation of several multipliers such as investments
multiplier, government expenditure multiplier and tax multiplier under different
assumptions of the tax function.
3.2 Lesson Learning Outcomes
By the end of this lecture, the learner should be able to:
3.2.1 Derive the multipliers under lump sum taxes
3.2.2 Derive the multipliers when tax is a function of income
3.2.1 Derivation of the expenditure multipliers under lump sum taxes
Expenditure multipliers are useful in telling us the amount by which equilibrium income
will change when aggregate demand component change by one unit. In this section, we
shall develop multipliers for changes in investment and government purchases and also for
shifts in the tax schedules beginning with an economy where taxes are levied as lump- sum.
When taxes are a fixed sum, t , then basic equilibrium condition becomes:
c( y t ) i g y c( y t ) s( y t ) t ………………………………………….. (3.1)
Eliminating the consumption component, we get:
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i g y c( y t ) s( y t )) t ………………………………………………… (3.2)
From equation (3.2):
y c( y t ) i g …………………………………………………………………. (3.3)
We can derive general expression showing changes in y following changes in t , i and g
by differentiating that expression to obtain:
dy c / (dy d t ) d i dg
dy c / dy c / d t d i dg
dy c / dy c / d t d i dg
dy(1 c / ) c / d t d i dg
c / d t d i dg
dy
1 c/ …………………………………………………………… (3.4)
Equation (3.4) is a general multiplier expression.
To obtain the multiplier for d i , we set d t and dg equals to zero and then divide by d i to
obtain:
dy 1
di 1 c/
…………………………………………………………………………. (3.5)
Equation 3.5 is the Investment Multiplier.
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Example
dy 1
If c / = 0.7, then
3.3
di 1 0.7
Interpretation
A unit increase in investment demand yields 3.3 units increase in income and vice versa.
Government Expenditure Multiplier
From equation (3.4);
c / d t d i dg
dy
1 c/ ……………………………………………………………… (3.4)
To obtain the multiplier for government expenditure, we set d t and d i equals to zero and
then divide by dg to obtain:
dy 1
………………………………………………………………………….. (3.6)
dg 1 c /
(3.6) is the expression for government expenditure multiplier.
Example
/
If c = 0.7, then
𝑑𝑦 1
= 1−0.3 = 3.33
𝑑𝑔
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Interpretation
A unit increase in government expenditure yields 3.3 units increase in income and vice
versa.
Tax Multiplier
From equation (3.4);
c / d t d i dg
dy
1 c/ ……………………………………………………………… (3.4)
To obtain the tax multiplier, we set dg and d i equals to zero and then divide by d t to
obtain:
………………………………………………………………….. (3.7)
(3.7) is the expression for tax multiplier.
Example
/
If c = 0.7, then
𝑑𝑦 −0.7
= = −2.33
𝑑𝑡̅ 1 − 0.7
Interpretation
A unit increase in taxes yields 2.33 units decrease in income and vice versa.
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The balanced budget multiplier
The balance budget exists when dg d t and if this is substituted into equation (3.4) while
setting d i equals to zero, we get:
c / dg dg dg (1 c / )
dy
1 c/ 1 c/
Hence balanced budget multiplier:
dy (1 c / )
1
dg 1 c/
This tells us that if government expenditure changes by one shilling, output also increase
by one shilling.
3.2.2 Multipliers when taxes are a function of income
When tax revenues are an increasing function of income, then the basic equilibrium
condition becomes:
c( y t ( y )) i g y c( y ( y )) s( y t ( y )) t ( y ) …………………………. (3.8)
Eliminating the consumption component, we obtain:
i g y c( y t ( y )) s( y t ( y)) t ( y ) …………………………… …………. (3.9)
To obtain the general form of the multiplier with a given tax structure, we differentiate the
LHS of equation (3.8) to obtain:
dy c / (dy t / dy d i dg
dy c / (1 t / )dy d i dg
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dy c / (1 t / )dy d i dg
dy[1 c / (1 t / )] d i dg
d i dg
dy
1 c / (1 t / ) ………………………………………………………………… (3.10)
Equation (3.10) is the general equilibrium multiplier expression and the introduction of the
tax has reduced the multiplier. Diagrammatically, this can be presented as in Figure 3.1.
Figure 3.1
We can observe that with tax revenues fixed at t , an increase in investment demand from
i 0 to i 1 raises equilibrium income from yo to y1. When tax revenues are an increasing
function of income, the same investment increase only raises y from yo to y2. The presence
of the tax function therefore reduces the increase in disposable income relative to those in
total income. The tax system therefore acts as a built-in-stabilizer, reducing the change in
income due to a change in investments and government expenditure.
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The tax rate multiplier
The tax rate multiplier is very relevant in stabilization policy decision involving tax
changes. The tax function can be simplified by assuming that tax revenues are proportional
to income so that; t(y)=Ty where T=% tax rate. The basic equilibrium condition now
becomes:
y c( y T y ) i g ……….....……………………………………………………. (3.11)
Since d ( T y ) is approximately equal to T dy yd T then the differential of equation (3.11)
becomes:
dy c / (dy T dy yd T ) d i dg
c / (1 T )dy yd T d i dg
Therefore:
d i dg c / yd T
dy
1 c / (1 T ) ……………………………………………………………… (3.12)
(3.12) is the general expression for the multiplier.
Holding 𝑔 and 𝑖 constant, the tax rate multiplier is given as:
……………………………………………..……. (3.13)
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Investments multiplier
From:
d i dg c / yd T
dy
1 c / (1 T )
Holding 𝑔 and 𝑇 constant, the Investments multiplier is given as:
…………………………………………………….. (3.14)
Government Expenditure Multiplier
From:
d i dg c / yd T
dy
1 c / (1 T )
Holding 𝑖 and 𝑇 constant, the government expenditure multiplier is given by:
……………………………………………………… (3.15)
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3.3 Self-Assessment Questions
Compute the investments, tax rate and government expenditure multiplier given that:
𝑐 ′ = 0.7 𝑎𝑛𝑑 𝑇 = 0.25
Comment on your results in comparison to the case of lump sum taxes
3.4 E-References
1. Mankiw, N. Gregory (2014). Principles of Economics. Cengage Learning. ISBN
978-1-305-15604-3.
2. Branson William, (1989) Macroeconomic Theory and Policy, Harper and Row
Publishers, 3rd edition.
3. Romer, David (2011). Advanced Macroeconomics, 4th edition. The McgrawHill.
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