be able to identify several ways in which an increase in government spending crowds out other types of aggregate demand; and
understand how different means of financing an increase in government spending lead to different multiplier values.
7.1 Automatic Stabilizers
When students first learn about the multiplier, they jump to the conclusion that it is better to have a large rather than a small multiplier to enable the government to push the economy out of a recession more easily. There are two main reasons why this conclusion is not warranted:
1. Our knowledge of the economy and how it operates is imperfect, so deciding when and by how much to change government spending is not an exact science. A large multiplier magnifies any mistake by the government.
2. A large multiplier means that any change in aggregate demand, not just a change in government spending, has a substantive impact on economic activity. All economies are subject to irregular changes in aggregate demand, such as changes in export demand due to changes in foreign economies, or changes in investment demand due to new inventions. With a high multiplier, these changes have a large impact on economic activity, creating instability.
In light of these two problems, anything that causes the multiplier to become smaller is considered desirable because it insulates the economy from the effects of policy errors and aggregate demand shocks. Several phenomena play this role in the economy and are consequently called automatic stabilizers, although some economists reserve that term for government policies that lower the multiplier value. Each of the following examples is explained in the context of an increase in aggregate demand. They would operate in reverse if aggregate demand were to decrease.
The increase in income at each stage of the multiplier process is not all available for spending; some is required to pay income taxes on the extra income earned. Because taxes inhibit the rise in consumption spending, aggregate demand does not increase by as much at each stage of the multiplier process, so, the multiplier process does not stimulate income by as much.