Fiscal multiplier represents the magnitude of the impact of fiscal stimulus on economic output. 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%.
This term is also called the Keynesian multiplier or multiplier effect.
The logic behind the Fiscal Multiplier
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 that 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.
More role from governments
Keynes views both the private and public sectors contribute 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.
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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.
Formula and calculation of Keynesian multiplier effects
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 the consumption of goods and services. 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, 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)]
Drawbacks of the Keynesian multiplier
Not all household consumption is financed through income. Some types of purchases are financed with bank loans, for example, the purchase of a car and a house.
Because they have to pay debts, households spend less income on the consumption of other goods and services. As a result, the marginal propensity to consume is reduced, and the multiplier effect is lower than that proposed by Keynesians.
Then, the multiplier effect is also small when the economy depends on imports. Government stimulus (for example, decreasing income tax) ultimately do not increase domestic production and household income. Instead, the effect on income is transferred abroad.