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Fiscal Multiplier

Fiscal Multiplier

The GDP is $900 billion, and the government wants to increase aggregate output by another $200 billion by spending more. How much should the government spend to increase the real GDP by $200 billion? Can the government do this? Do these sound interesting? Read on to find out how government can boost aggregate output and more.

Fiscal Multiplier Meaning

To understand how the fiscal multiplier works, let's consider what would happen if the government was to buy $20 billion worth of products from Boeing. There would be economic consequences if the government decided to purchase Boeing's $20 billion worth of products. The increased demand from the government will almost immediately affect profitability, input purchases, and hiring at Boeing. Then, after the employees see increased salaries and the business owners see larger profits, they react by spending more on their purchases of consumer goods. Therefore, the demand for the products from other companies in the economy increases as a direct consequence of the government's purchase from Boeing.

The fiscal multiplier tells us how much a change in fiscal policy, such as government purchases and tax policy, will lead to further changes in the economy's aggregate demand.

Purchases made by the government have a multiplier impact on aggregate demand. This is because each dollar spent by the government can boost the aggregate demand for goods and services by more than one dollar. Even after this first round is over, the multiplier effect will still be in effect.

When consumer spending goes up, businesses that manufacture consumer products respond by increasing the number of workers they employ. A rise in income encourages increased consumer spending, leading to another cycle. As a result, there is a positive feedback loop at work: expanded demand results in more revenue, leading to a further increase in demand. When all of these impacts are combined, the cumulative influence on the number of products and services consumers desire is considerably more than the initial impulse caused by an increase in government expenditure.

Fiscal Multiplier Effect Graph

The multiplier effect is illustrated in Figure 1 below.

multiplier effect of fiscal policy aggregate demand curve shifts studysmarter

Figure 1. The aggregate demand curve shifts as a result of the multiplier effect, StudySmarter Originals

The rise in government purchases of precisely $20 billion moves the aggregate-demand curve from AD1 to AD2 at the beginning, which is a rightward shift of exactly $20 billion. However, the aggregate demand curve shifts even more to AD3 when consumers and firms react by increasing their spending.

Fiscal Multiplier Formula

The government can influence the economy by either changing its spending, changing how much to collect in taxes, or doing both. As such, there are three fiscal multipliers for which we have to consider: spending multiplier, tax multiplier, and balanced budget multiplier.

Expenditure multiplier formula

The expenditure multiplier helps us determine how much an increase in one autonomous variable, such as an increase in government spending, changes a country's real GDP. When there is an increase in government purchases of goods and services, it will cause additional purchases to happen as a result of more money flowing to the hands of businesses and individuals. This, in turn, will cause further increases in real GDP.

Let's consider a simple case to find out about the effect of an increase in government spending on the economy. To do that, assume that the entire money that the government spends goes to households. Individuals can consume parts of this money and save the rest. Therefore, we have to take into account how much households are going to spend. The marginal propensity to consume (MPC) describes the portion of disposable income that an individual spends. This will help us find out how much an increase in government spending changes the real GDP.

The formula for the expenditure multiplier is:

If individuals spend 80% percent of their disposable income and save the remaining, the expenditure multiplier is:

This means that for a one-dollar increase in government spending, the real GDP will increase by five dollars. If the government spends $10 billion, the real GDP will increase by $50 billion.

We have an excellent article on the spending multiplier: Expenditure Multiplier. Check it out!

Tax multiplier formula

Tax multiplier refers to the change in real GDP due to a change in taxes. The tax multiplier is quite helpful in helping governments design the right tax rate regime. They do this by analyzing how much different tax rates would affect the real GDP so that they can change it according to the desired real GDP level.

However, one important thing to note is that aggregate demand changes are not proportional to the increase or decrease in taxes. That is because we don't always consume our entire disposable income; rather, we save some of it. So, if the taxes were to decrease, and as a result, we'd have more disposable income, it doesn't mean that we will spend it all. Hence, the change in aggregate demand will be less than the change in taxes.

The equation for the tax multiplier is as follows:

,

Where MPC is the marginal propensity to consume.

Note that the denominator (1 - MPC) is equal to the marginal propensity to save (MPS), which describes the portion of disposable income that an individual saves.

A change in government transfers works in a similar way. You can think of an increase in transfer payments as a decrease in tax collection. It increases people's disposable incomes just like a decrease in taxes would do.

Balanced budget multiplier formula

We discussed the spending multiplier and the tax multiplier. What happens when the government increases taxes to fund some of its current government expenditures? In such a case, both multipliers will play a role in the aggregate demand. The impact of that is analyzed using the balanced budget multiplier.

The balanced budget multiplier is found by summing up the spending and tax multiplier.

As the balanced budget multiplier equals one, it means that whenever the government increases its spending by 1 dollar by funding it through tax increases, it increases aggregate spending by 1 dollar.

Fiscal Multiplier Derivation

Using some basic algebra, we can derive the formula for the size of the multiplier effect that takes place when an increase in government purchases causes an increase in disposable income, which in turn increases consumer spending. This formula considers that an increase in government purchases causes an increase in consumer spending. The marginal propensity to spend, known as MPC, is crucial in this formula since it indicates the proportion of a household's additional disposable income spent rather than saved.

Take, for instance, the case when the marginal tendency to spend is three-quarters. This indicates that a family will pay $0.75 (three-quarters of a dollar) and put $0.25 away for savings for every additional dollar that the household earns.

Consider the case when the U.S government spends $20 billion in purchases. Suppose the MPC is at three-quarters, when the employees and business owners receive $20 billion from the government contract, they will raise their consumer spending by three-quarters of $20 billion, which is $15 billion.

Following the impacts in sequential order allows us to calculate the influence of a shift in government spending on total market demand.

The rise in consumer spending of $15 billion causes a rise in income for the employees and owners of the businesses that manufacture the items that consumers buy.

The money that the business owners and employees spend will cause another increase in consumption as other people are receiving more income too.

To derive the formula will have to add all these effects together.

The multiplier can then be written as:

This provides an infinite geometric series, and from math, we know that:

Hence multiplier is:

Fiscal Multiplier Example

Assume that the U.S government wants to increase taxes by $20 billion dollars. The marginal propensity to consume (MPC) is 0.6 and the marginal propensity to save (MPS) is 0.4. What does it mean for the real GDP, and by how much will it change?

To find out by how much the real GDP in the economy would be impacted, we will have to consider the tax multiplier.

When we know the tax multiplier, we can find out by how much the GDP will change.

The real GDP will decrease by 30 billion as a result of the tax increase.

Let's consider another example. Let's assume that the government wants to increase its spending on public hospitals. For this, the government has prepared a budget of $25 billion. The marginal propensity to consume is 0.8. By how much would the GDP increase if the government was to spend $25 billion on hospitals?

To determine the impact that the increase in government spending has on the GDP, we will have to consider the spending multiplier.

The formula for spending multiplier is

This means that for every dollar that the government spends, the real GDP will increase by five times as much.

In our case, the government is spending $25 billion. In that case,

That means that the real GDP will increase by $125 billion.

Fiscal Multiplier - Key Takeaways

  • A change in government expenditure leads to further changes in total spending and total output.
  • The expenditure multiplier quantifies the change in aggregate demand as a result of a change in autonomous spendings, such as government purchases.
  • The tax multiplier quantifies the change in the size of aggregate demand as a result of a tax change.
  • The expenditure multiplier and tax multiplier depend on the marginal propensity to consume.
  • The marginal propensity to consume (MPC) refers to the part of the disposable income that is not consumed. The marginal propensity to save (MPS) and the MPC add up to 1.

Frequently Asked Questions about Fiscal Multiplier

The government spends $25 billion dollars on hospitals and increases real GDP by $125 billion.

Spending multiplier = 1 / (1-MPC)

Tax multiplier = -MPC / (1-MPC)

Using some basic algebra, we can derive the formula for the size of the multiplier effect that takes place when an increase in government purchases causes increases in consumer spending. 

The fiscal multiplier tells us how much a change in input such as government spending leads to a more considerable change in aggregate demand / real GDP.


On the other hand, the money multiplier is a concept from monetary economics. It tells us how much commercial bank money can be created with central bank money under a fractional-reserve banking system.

The marginal propensity to consume (MPC)

Final Fiscal Multiplier Quiz

Question

What is fiscal multiplier?

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Answer

A fiscal multiplier occurs when a change in input such as government spending leads to a more considerable change in output such as GDP.

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Question

What affects the fiscal multiplier?

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Answer

The marginal propensity to consume (MPC).

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Question

Does government expenditure have a multiplier impact on aggregate demand?

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Answer

Purchases made by the government have a multiplier impact on aggregate demand. 

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Question

Why purchases made by the government have a multiplier effect on aggregate demand?

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Answer

This is because each dollar spent by the government has the potential to enhance the aggregate demand for goods and services by more than one dollar. Even after this first round is over, the multiplier effect will still be in effect. 

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Question

How many fiscal multipliers are there?

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Answer

The government can influence the economy by either increasing its spending, reducing taxes, or both. As such there are three fiscal multipliers for which we have to consider their formula namely, spending multiplier, tax multiplier, and balanced budget multiplier.

Show question

Question

What is the spending multiplier?

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Answer

Spending multiplier helps us find out by how much an increase in one autonomous variable such an increase in government spending changes the real GDP of a country.

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Question

What is the Marginal propensity to consume?

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Answer

MPC refers to the part of an individuals income that is consumed.

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Question

What does it mean when the spending multiplier is equal to 4? 

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Answer

This means that for any dollar increase in government spending the real GDP will increase by four dollars.

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Question

If the spending multiplier is 5 and the government spending increases by 10 billion, how much will the GDP increase?

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Answer

5 x $10 billion = $ 50 billion will be the increase in GDP.

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Question

What is the tax multiplier?

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Answer

Tax multiplier refers to the change in real GDP due to a tax change. 

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Question

If the MPC is .65, what is the spending multiplier?

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Answer

2.85

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Question

Explain what happens to the GDP if the government spends $1.5 trillion, and the spending multiplier is 3.

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Answer

GDP will increase by $4.5 trillion

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Question

What is the tax multiplier if the MPC is .33?

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Answer

.50

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Question

Explain what happens to GDP if taxes decrease by $2 million if the MPC is .8

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Answer

GDP will grow by $8 million

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Question

Explain how GDP is affected by an increase in government spending of $5 trillion if the MPC is .6

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Answer

GDP will increase by $12.5 trillion

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Question

The U.S. government is asking for your help in determining the change in GDP. Next year, the government plans to spend $500 billion and the MPC is .7. What is the change in GDP expected to be?

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Answer

GDP will grow by $1,666 billion

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Question

Assume that the U.S government wants to increase taxes by $30 billion dollars. The marginal propensity to save (MPS) is 0.8. What does it mean for the real GDP?

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Answer

GDP will decrease by $7.5 billion

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Question

What are the three types of fiscal multipliers?

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Answer

Balanced Budget

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Question

True or False: Another way to write the tax multiplier equation is: –MPC/MPS

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Answer

True

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Question

True or False: Taxes and GDP have an inverse relationship

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Answer

True

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Question

True or False: Government spending and GDP have an inverse relationship

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Answer

False

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Question

Which of the following directly affects the multiplier?

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Answer

MPS

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Question

If the MPC is .8, what will the MPS be?

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Answer

.2

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Question

The U.S. government is asking for your help. They want to know how much they should spend if their desired GDP output is $800 billion and the MPC is .6.

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Answer

$320 billion

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Question

The U.S. government is asking for your help. They want to know how much they should spend if their desired GDP output is $950 billion and the MPC is .4.

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Answer

Around $572 billion

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Question

True or False: You cannot find the expenditure or tax multiplier if you only have the MPS.

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Answer

False

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Question

True or False: MPS and MPC always add up to 1.

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Answer

True

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Question

A change in government spending leads to a change in ______

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Answer

Output

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Question

True or False: The spending multiplier is stronger than the tax multiplier

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Answer

True

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Question

If the MPS is .4, what is the MPC?

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Answer

.6

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