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.