The Keynesian multiplier

The followers of Keynes believed that fiscal policy can be a powerful lever to move the economy because the effect of an increase in spending or a cut in taxes would be multiplied by stimulating additional demand for consumption goods by households.

Imagine that in the midst of a recession the government spends $100 million for new highway bridge construction. Idle workers and machines will be put to work on bridge construction, resulting in an increase in GDP of $100 million over the period of construction. In addition, construction workers and firm owners will find that their incomes have risen by $100 million. These people will spend at least part of that $100 million on additional consumer goods and services, but they will also save some of the additional income. This sets off a chain reaction in which additional spending boosts the income of sellers of goods and services who, in turn, spend more on other goods and services.

Let's build a simple model to see how the marginal propensity to consume determines the impact of a change in government spending on GDP. We begin with a hypothetical $100 increase in government purchases of goods and services in an economy which consists of households having identical marginal propensity to consume which we will abbreviate mpc. To simplify the model, households in our model provide goods or services directly to the government, so we can imagine that the government pays the $100 to one household, say household #1.

Now household #1 will spend the fraction equal to its mpc of that additional income to purchase consumption goods, and for simplicity we suppose that the purchase is made directly from household #2. Seeing its disposable income rise by $1 times mpc, household #2 will purchase additional consumer goods worth mpc times that amount, say from household #3. We see that the additional consumption spending at each step of this chain reaction is mpc times the amount at the prior step.

This table depicts a chain reaction of spending which continues on indefinitely as it produces ever smaller increments to GDP.

Round 1

Initial Spending by Govt

100 m

Round 2

 80% of 100 m spend

80

Round 3

80% of 80m spend

64

Round 4

80% of 64m spend

51.2

Round5

80% of 51.20 m spend

40.96

Round 6

80% of 40.96m spend

32.768

Round 7-19

Goes on till all money is spent

 

Round 20

60% of 0.01

0.01

Total spending, including the initial spending by government

249.99

Components of Multiplier

  • Marginal propensity to consume (MPC):Proportion of income which is spent by the household
  • Marginal propensity to withdraw (MPW): Proportion of income which does not re-enter the cycle. It is the total of MPS+MRT+MPM.
  • Marginal propensity to save (MPS): Proportion of income which is saved.
  • Marginal rate of taxation (MRT): Proportion of income which goes out as taxes to government
  • Marginal propensity to import (MPM): Proportion of income which goes out as import expenditure.

Formula

1/(1-mpc)

Or 1/mpw

Or 1/mps+mrt+mpm

 

The government spending and tax cut multipliers depend on the marginal propensity to consume, the fraction of each additional dollar of disposable income that households will spend on consumption. If the mpc is large then the multipliers are large, but if the mpc is zero, then government spending will have no multiplier effect on the economy and a tax cut will have no effect at all. The key parameter is the mpc and the key question is: how large is the mpc?

Example

Calculate the multiplier for any economy where the MPC=.75

Investment = $50,000

The result will be….

1/1-.75 = 1/.25 = 4

i.e. 4X50,000=$200,000

Thus any injection of $50,000 into the economy will lead to 4 times increase in National income i.e. $200,000

 

 

Watch a Video

Watch a Video

New Youtube Channel - ThinkIGCSE

Hi Everyone, I have launched a new YouTube channel with more than a 100 videos on  Economics and Business Studies, tailored specifically for IGCSE and A Level and IBDP students.

Subscribe now and join us on this learning journey: @thinkIGCSE

Exciting News!

IMPORTANT MESSAGE

Quizzes and worksheets on this website have been developed in Flash format. Flash is no more supported by browsers. Therefore, you might see blank pages on some instances. Install Flash player plugin for Chrome from Chrome Web Store. Click here 

Similarly, for other web browsers you will have to activate the relevant flash player plugins.

JOIN OUR ONLINE COURSES

WHO'S ONLINE

We have 636 guests and no members online

Crosswords

PDF FILE

Download

MindMaps

PDF FILE

Download

Save
Cookies user preferences
We use cookies to ensure you to get the best experience on our website. If you decline the use of cookies, this website may not function as expected.
Accept all
Decline all
Read more
Analytics
Tools used to analyze the data to measure the effectiveness of a website and to understand how it works.
Google Analytics
Our website uses Google Analytics to understand how you interact with our site and improve your browsing experience. These cookies collect information in an anonymous form, including the number of visitors to the site, where visitors have come from, and the pages they visited. The data helps us analyze trends and user behavior to enhance our website's functionality and content.
Accept
Decline
Marketing
Set of techniques which have for object the commercial strategy and in particular the market study.
Marketing
Our website uses Google marketing cookies to deliver personalized ads and measure the effectiveness of our advertising campaigns. These cookies track your online activity to help us show you relevant ads on Google services and partner websites.
Accept
Decline