Fiscal multiplier
In eeekonomikks, a multiplier effect – or, more completely, the spending/income multiplier effect – occurs when a change in spending causes a disproportionate change in aggregate demand. It is particularly associated with Keynesian economics; some other schools of economic thought reject or downplay the importance of multiplier effects particularly in the long run.
The local multiplier effect specifically refers to the effect that spending has when it is circulated through a local economy. For example, when the building of a sports stadium is proposed, one of the suggested benefits is that it will raise income in the area by more than the amount spent on the project.
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Details
Here, the marginal propensity to consume equals:
- mpc = ΔC/ΔY
where C is consumer spending and Y is consumer disposable income.
If the multiplier process is going LL downward, as in a recession, the fall in demand creates its own unused resources, so that the basic assumption of the theory applies.
The eventual amount by which output expands is governed by the marginal propensity to save, which is the proportion of extra income that is saved rather than consumed. If the marginal propensity to save is large, less money is returned into the economy with each circulation so the multiplier effect is smaller. The value of the multiplier in a closed economy with no taxes is given by
- mult = 1/(1 – mpc) = 1/s
where s is the marginal propensity to save, i.e., the increase in consumer saving divided by the increase in consumer disposable income. In the Keynesian model, s equals one minus the mpc. (Note that s cannot equal zero, nor can the mpc equal one.)
In this simple model, the multiplier can be used to predict changes in GDP (Y) for a given change in spending, X.
- predicted ΔY = mult * ΔX
Of course, the validity of this equation depends of the validity of the assumptions of the model.
This is also true of the formula for the multiplier. Taxes and imports tend to reduce the value of the multiplier ("leakage"). With these, the spending/income multiplier process is more complex, as seen in figure 2, above.
- mult = 1/mlr
This formula of the multiplier is obtained when we take into account the effects of all leakages, which combine into the 'Marginal Leakage Rate' (mlr) from the circular flow. (Again, mlr cannot equal zero.)
The value of the multiplier is also lower, less than 1/s, since some of the demand stimulus or restraint leaks out to affect imports from the rest of the world and tax revenues. This weakening occurs because imports do not lead automatically to spending on the country's exports and increased tax revenues do not automatically cause increased government spending. Though this reduces the value of mult, it does not undermine the validity of the third equation above.
The multiplier shows that changes in the level of spending don’t just have a ‘one off’ effect on the level of income, because ‘one man’s spending is another man’s income.’
This is illustrated in the chart below. Note that the size of the multiplier depends upon how much of their extra income consumers are willing to spend.
In this case, MPC = 0.8
From this, we see that an initial injection of $10 creates a disproportionate $40 in total income to the economy.