Fiscal Multiplier is a powerful concept in economics that helps us understand the impact of government spending on an economy’s overall health. It measures how much a change in government spending, either through increased spending or tax cuts, ultimately affects a nation’s Gross Domestic Product (GDP). In simpler terms, the Fiscal Multiplier tells us how much a government’s spending boost translates into a larger increase in economic output.
Understanding the fiscal multiplier
The fiscal multiplier measures how much a change in government spending or tax policy affects a country’s economic output or gross domestic product (GDP). The initial stimulus for expenditure usually results in a higher final increase in the gross domestic product (GDP). For example, when consumption increases by 1%, the GDP will increase by more than 1%.
The key idea behind the multiplier is that an initial government stimulus, like increased spending on infrastructure projects, has a rippling effect throughout the economy. Businesses that receive government contracts hire more workers, who then spend their wages on goods and services. This increased consumption by workers leads to even more hiring and spending, ultimately resulting in a larger overall increase in GDP compared to the initial government stimulus itself.
This concept is also known as the Keynesian multiplier or multiplier effect, named after economist John Maynard Keynes, who emphasized its importance during economic downturns.
Addressing inadequate demand
John Maynard Keynes is one of the influential thinkers in modern economics. In 1936, he wrote a book called “The General Theory of Employment, Interest, and Money,” to explain short-term economic fluctuations, especially concerning the Great Depression in the early 1930s. The work became monumental and changed economic thinking at the time.
He argues that depression occurs due to inadequate aggregate demand. To get out of this condition, the government must intervene. Economics will not immediately return to equilibrium by itself, as classical economic thought at the time.
Keynes called for increased government spending. Increased government spending will encourage increased demand for goods and services. Because demand is stronger, businesses will increase production and absorb more labor. As a result, spending stimulus by the government ultimately revives economic activity.
Government vs. Private Sector
Keynes views both the private and public sectors as contributing to driving aggregate demand. But, the private contribution is not enough. Business investment expenditure highly depends on economic growth. When economic growth falls, It makes more sense for them to save money by reducing investment.
On the other hand, government spending is more autonomous and does not depend on economic growth. Instead, it depends on government discretion.
For this reason, during a recession, the government should take a more significant role in restoring the economy. Governments can increase spending or reduce tax rates. An increase in transfer payments, for example, will drive household consumption because they have more money. Likewise, personal tax cuts also result in higher disposable income, which they can use for the consumption of goods and services.
Measuring fiscal multiplier
Keynes uses the concept of changing aggregate demand to develop a multiplier effect on the economy. In the graph, when aggregate demand increases from AD1 to AD2, it causes an increase in output from Y1 to Y2. The multiplier effect then works and pushes up aggregate demand towards AD3, so the production will also increase to Y3.
Keynes points out that the value of the multiplier depends on the portion of the extra money spent on goods and services consumption. In other words, it depends on the marginal propensity to consume (MPC).
Fiscal multiplier formula
The marginal propensity to consume is a portion of the additional household income (Y) spent on the consumption of goods and suits (C). Mathematically, the formula is:
- MPC = ΔC / ΔY
The basic idea of the MPC multiplier effect is relatively simple. When consumption increases, producers will increase production to meet demand. They will employ more workers.
Increased job creation contributes to increased household income. When household income rises, the consumption of goods and services will also increase further. Producers will return to respond by increasing production. An increase in production means more employment and an increase in household income.
The process continues. And, as a result, an increase in consumption will stimulate growth in production and income in the economy several times. That is what we call the Keynesian multiplier.
Mathematically, Keynes formulated the multiplier as follows:
- Keynesian Multiplier = 1 / (1 – MPC)
For example, when an additional household income is IDR 100 and spent IDR 60 for consumption, the MPC is 0.6. From the use of Rp60, the multiplier effect on the economy is 2.5 = 1 / (1-0.6).
Please note that the formula above still ignores the taxes that households pay. If we take into account taxes in the Keynesian multiplier, the above formula becomes:
- 1 / [1-MPC (1-t)]
Limitations of the fiscal multiplier
The Fiscal Multiplier is a powerful tool for understanding how government spending and tax policies influence economic growth (GDP). However, it’s important to consider some key factors that can dampen the multiplier effect, leading to a less pronounced impact on the economy than initially expected.
Debt
One important limitation centers on how households actually finance their spending. The multiplier assumes that increased government spending translates directly into higher consumption by households.
But in reality, many households, especially for larger purchases like cars and houses, rely on loans. Loan repayments then act as a drag on disposable income, the money households have left after taxes for everyday spending.
As debt obligations rise, a larger portion of income goes towards loan payments, leaving less discretionary spending on other goods and services. This ultimately reduces the Marginal Propensity to Consume (MPC) – the portion of additional income spent on consumption – and weakens the multiplier effect.
In simpler terms, the initial government stimulus has a smaller impact on overall economic growth compared to a scenario where all spending comes directly from income. Imagine a house party with a broken keg. People might initially spend more on drinks, but if they have to pay back loans taken out to cover those drinks, they’ll have less money for other party supplies or going out later, limiting the overall economic boost.
Imports
International trade is another factor that can hinder the multiplier effect. The multiplier assumes the initial government stimulus circulates within the domestic economy.
However, in economies that rely heavily on imports, a portion of the stimulus leaks out. It’s like pouring water into a bucket with a hole-the stimulus fills the bucket (domestic economy), but some leaks out through imports, reducing the overall impact.
For instance, a tax cut might lead to increased spending on imported electronics or clothing. This money goes to foreign producers instead of boosting domestic production and income.
In such cases, the multiplier effect is weaker because the initial stimulus has a less pronounced impact on domestic economic activity. Economies with a high propensity to import may see a smaller overall boost from government spending compared to those that rely more on domestic production.
Crowding out
In some situations, government spending can “crowd out” private investment. This occurs when government borrowing to finance its spending drives up interest rates.
Higher interest rates make it more expensive for businesses to borrow money to invest in new projects or expand their operations. This can lead to slower economic growth and a weaker multiplier effect.
Imagine the government competing with businesses for a limited pool of loanable funds. If the government borrows heavily, it can drive up interest rates, making it more expensive for businesses to borrow, potentially slowing down economic growth.
