Readers Question: Hi – I hope to explain the fiscal multiplier effect to a bunch of non-economists (business professionals). I’m planning to start with the Keynesian GDP equation and work from there. Where I am stumped is how to represent the effect of a reduction in tax (lump sum or whatever) on the GDP equation.
AD = C+I + G + X – M
The multiplier effect states than an injection (e.g. government spending) into the economy can lead to a bigger final increase on Real GDP. E.g. if Government spending of £1bn led to an increase in real GDP of £1.5bn, the multiplier effect would be 1.5
- A tax cut has no effect on government spending, but, it should effect C and I.
- For example, imagine the government cut VAT from 17.5% to 15%. This has two effects.
- Firstly, if consumers maintain the same spending habits, they will have more disposable income left over to buy more goods. Secondly, they may be encouraged to buy goods (especially expensive electrical goods) e.t.c because they are cheaper.
- Therefore, in theory, a tax cut should boost consumer spending and this leads to an overall rise in AD.
- This means firms will get an increase in orders and sell more goods. This increase in output, will encourage some firms to hire more workers to meet higher demand. Therefore, these workers will now have higher incomes and they will spend more. This is why there is a multiplier effect. Extra spending benefits others in the economy.
The size of the multiplier will depend on what % of the extra income people spend on UK goods.
For example, if people buy imports or save the extra money, the multiplier will be limited.
Monetarists argue the fiscal multiplier will be limited by the crowding out effect. E.g. governments increase AD through higher spending or tax cuts, but, the rise in borrowing leads to a decline in private sector investment. Therefore, there is no overall increase in AD.
However, in a recession, the private sector typically has a glut of non productive savings, therefore, the crowding out effect is limited.
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Thanks for that – clears up some questions. You raise that M should increase as well – in representing the effect of the multiplier, I’m thinking that C and I should increase by enough to cancel out the increase in M, whilst maintaining the correct ratio of each propensity (to consume, to invest, to import)? Hope that makes sense.
M (imports) will rise as C (consumption) rises. Typically M may account for say 0.4 of any rise in C.
So if you get an extra £10, £4 goes on imports, £3 on taxes leaving an increase in C of £3.
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