Fiscal Policy Multipliers

Keynesian Multiplier

The Multiplier

• Fiscal policy has an amplified effect on the economy.

• The change in real GDP is larger than the initial change in aggregate spending due to the multiplier effect.

Consumption Function

• Formula: C = AC + mpc * YD

  • Where C is consumption, AC is autonomous consumption, mpc is the marginal propensity to consume, and YD is disposable income.

• Marginal Propensity to Consume (MPC):

  • Defines the increase in consumer spending when disposable income rises by $1.

  • Ranges between 0 < mpc < 1.

• Marginal Propensity to Save (MPS):

  • mps = 1 - mpc.

• Example Calculation:

  • If income rises by $10 and mpc is 0.8, consumption will rise by:

    • 10 * 0.8 = $8.

Aggregate Expenditure (AE)

• Formula: AE = C + I + G + NX

  • Where I is investment, G is government spending, and NX is net exports.

• Expanded Formula:

  • AE = AC + mpc * YD + I + G + NX (assuming T and TR are zero).

Multiplier for Autonomous Expenditure

• Equilibrium Condition: Y = AE

Fiscal Policy Multiplier - Government Purchases

• Multiplier Formula:

  • Y = 1 / (1 - MPC) * G

    • Where G is the change in government purchases.

Fiscal Policy Multiplier: T and TR

• Aggregate Expenditure with Transfers:

  • AE = C + I + G + NX

  • AE = AC + mpc * (Y - T + TR) + I + G + NX

    • Where T is taxes and TR is transfer payments.

Fiscal Policy Multiplier: T and TR (continued)

• New Multipliers Formulas:

  • Y = T / (1 - MPC)

  • Y = TR / (1 - MPC)

Comparison of Fiscal Policy Effects

• Hypothetical Effects with MPC of 0.5:

  • Effects of Government Purchases:

    • $50 billion rise in government purchases leads to:

    • First round: $50 billion

    • Second round: $25 billion

    • Third round: $12.5 billion

  • Effects of Government Transfer Payments:

    • $50 billion rise in transfer payments leads to:

      • First round: $25 billion

      • Second round: $12.5 billion

      • Third round: $6.25 billion

• Eventual Effect:

  • Total multiplier effect: $100 billion

  • Multiplier Calculation:

    • 1/(1 - MPC) = 1 / (1 - 0.5) = 2

    • MPC = 0.5

Fiscal Policy and the Multiplier

• The multiplier effect can be expressed as:

  • 1/(1 - MPC) is greater than MPC/(1 - MPC)

  • This indicates that any change in government purchases has a more substantial impact on the economy compared to equal-sized changes in taxes or transfers.