Question

Assume that a stimulus package would give $50 billion to taxpayers (Germany) before the end of 2020. The implication is that the rebates to the taxpayers will make them take the money and spend it—thus providing a stimulus to the German economy. But will they spend more? Will the $50 billion of tax rebates to German consumers increase aggregate expenditure by more than, less than, or $50 billion? Explain what variables should be taken into account to determine the size of the expansion?

Answer 1

The primary consideration here should be the MPC.

There is a marginal propensity to consume for all consumers.

Simultaneously there is the multiplier effect and the crowding out effect.

These 3 will influence what the expansion of the aggregate expenditure will be.

1) Marginal propensity to Consume: This is defined as the percentage of money in hands of the consumer which he/she is willing to spend. So If a consumer is given $100 and wants to spend $80, the marginal propensity to consume is 0.8. So if the marginal propensity to consume is high, most of the $50 billion rebate will be spent by the consumers and the aggregate expansion will rise substantially. However, if the marginal propensity to consume is low, then the growth in Aggregate demand will be low.

Combined with Marginal propensity to consume are the below 2 factors which decide whether the expansion will be more than or less than the relief of $50 billion

1) Multiplier Effect: When the government gives money in the hands of the consumers, the consumers spend the money. Let's say that the marginal propensity to consume is 0.8. So out of $50 billion, $40 billion will be spent by the consumers. This money goes into the hands of other people. Considering a fixed marginal propensity to consume, $32 billion will again be spent. Thus total expansion of $72 billion. If the marginal propensity to consume is high, then the growth rate will be faster, i.e. at a MPC of 0.9, the total expansion after 2 rounds will be $85.5 billion instead of $72 billion. However, the increase is always more than the total rebate. This is the multiplier effect.

2) Crowding out effect: Let us consider that the Government has given rebate of $50 billion. However, the government to fund it's project raises money from the market which could have been avoided if the $50 billion was with the government. Now since the government is raising money from market, it means there is a liquidity crunch. Banks will raise interest rates so that there is lesser borrowing. Lesser borrowing means lesser expansion. Also, at higher rates of interest, consumers will want to keep money in the banks to earn interest. Consumers may be getting $50 billion, but the consumption will not rise significantly. The other way the Government can raise funds is by selling bonds. Once the bonds are sold and the consumers buy them, the money in the hands of the consumers falls. This leads to lower spends. So the expenditure again falls.

So Marginal propensity to consumer determines the rate at which growth will occur.

The multiplier effect and crowding out effect tells us whether the growth will be more than or less than $50billion.

In this case, if the government does not need funds and is simply giving away the rebate, the consumers will have more money, interest rates will be low as the requirement for liquidity is low. So consumers instead of keeping money in the bank will spend it. Companies will borrow money and expand. Thus overall spends should increase. So the aggregate expenditure should ideally be above $50 billion. The rate at which the aggregate expenditure will grown will depend on the MPC of the consumers.

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