How does the multiplier effect influence fiscal policy?

The fiscal multiplier effect occurs when an initial injection into the economy causes a bigger final increase in national income.

Suppose the government pursued expansionary fiscal policy. The aim of expansionary fiscal policy is to increase aggregate demand (AD) and boost the rate of economic growth.

This could involve the government increasing public sector investment (e.g. £3bn of money to invest in building new roads) or it could involve tax cuts – financed by higher borrowing.

Effect of expansionary fiscal policy

increase-ad-inflation-growth
Impact of expansionary fiscal policy to increase AD

If there is spare capacity in the economy, then this increase in government spending will cause an increase in AD and an increase in real GDP.

Multiplier effect

The multiplier effect states that the initial injection may cause a bigger final increase in real GDP.

Suppose, the government employ workers to build roads – then they see an increase in real wages. However, they will also have more disposable income to spend and therefor will spend more in shops, clubs and restaurants. Therefore, related industries will also see a rise in demand, and the effect of this initial injection causes a bigger final increase.

multiplier-effect

In this case, workers receive more income and suppliers receive new orders. But Year 2, shows how there is a ‘knock on’ effect and other parts of the economy see a rise in demand as well. In this case, the initial injection of £3bn raises GDP by £3bn, but with the multiplier effect, the final increase is £4bn. The multiplier effect is 1.33.

multiplier-effectThe multiplier effect causes a bigger final increase in AD and bigger increase in real GDP.

Determining the size of the multiplier

The value of the multiplier depends upon the percentage of extra money that is spent on the domestic economy.

  • If people spend a high % of any extra income (a high mpc), then there will be a big multiplier effect.
  • However, if any extra money is withdrawn from the circular flow the multiplier effect will be very small.

multiplier-formula

 

  1. Marginal Propensity to Consume (mpc). This is a persons willingness to spend money – if a worker saved all his money there wouldn’t be an increase in GDP.
  2. Marginal Propensity to Withdraw (mpw). This is when money is withdrawn from the circular flow it includes mpt + mpm + mps
  3. The Marginal Propensity to Tax  (mpt)
  4. The Marginal Propensity to Import (mpm) – if we spend abroad it doesn’t increase UK demand.

What happens if multiplier effect is small?

Suppose the multiplier effect is very low 0.2. This means that with the injection of £3bn government spending – real GDP increases by only £0.6bn.

In this case, expansionary fiscal policy will not be very effective in boosting economic growth.

Why might the multiplier effect by small?

  • Marginal propensity to save. People may save the extra income. If consumers are pessimistic about the economic future, then they will save rather than spend – and there will be less of a knock on effect.
  • Ricardian equivalence. Suppose the government cut taxes to boost spending – How does the government finances the extra spending? If the government borrow money, national public sector debt will rise. Households may assume that this borrowing will lead to higher taxes in the future. And therefore not spend the extra income because they need to save for future tax rises.
  • Close to full capacity. If the economy is close to full capacity, then expansionary fiscal policy, may primarily cause inflation. And there will be little increase in real GDP.

ad increase - inflationCrowding out. If the economy is close to full capacity and the government borrow more – it may put upward pressure on interest rates and the private sector may have less to invest – if they lend money to the government. (See: Crowding out)

Multiplier in practise

As a rule of thumb, the IMF predict a muliplier of 0.5. Increase spending by £3bn – real GDP may increase by £1.5bn

In a recession, the fiscal multiplier effect tends to be bigger. This is because in a recession, there is no crowding out and there is spare capacity. In the period 2012-16, the IMF saw multipliers of up to 2. See: Fiscal multiplier in Eurozone

Mulitplier with US tax cuts

The US has recently cut taxes – how much will this boost economic growth? Since the economy is reasoanably close to full employment – we might expect a low mutiplier effect. Also, the tax cut gives disproportionate amount of income to the wealthy. Wealthy business owners tend to have a higher marginal propensity to save. Therefore, there will be less knock on effect to the rest of the economy.

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