Fiscal multiplier : Definition, Formula, Examples & Graph

Fiscal multiplier : Definition, Formula, Examples & Graph

According to the fiscal multiplier, when government expenses and tax are changed, they will lead some multiple of the increase or decrease of output level.

What is the meaning of multiplier in economics?

When there is a change in the injection into the Circular Flow of Income, the multiplier effect will lead to the national income changing in a proportionately large amount. The national income will be changed by greater than the initial injection spending. These initial spendings are investment (I), government expenditure (G), and exports (X).

As a result of every increase in injection spending, the new demand is created into the circular flow of income. Because when extra injection can increase spending and this will increase the national income level.

In other words, in economics, the multiplier effect is an economic parameter that can be used to understand the economic impact of changing the money flow. As a result of the changes in the money flow, there will be changes in the national demand level. The multiplier effect is determined as the number of times output increases for every increase in input.

Types of Multiplier

What are the different types of multipliers in economics?

When we learn macroeconomics, we find different types of multipliers such as investment multiplier, earnings multiplier, Keynesian multiplier, and fiscal multiplier. These multipliers help to study the behavior of an economy as a whole.

In this article we will consider about the fiscal multiplier

Fiscal multiplier

Fiscal multiplier meaning

Does fiscal policy have a multiplier effect?

According to the fiscal multiplier, when government expenses and tax are changed, they will lead some multiple of the increase or decrease of output level.

In other words, fiscal multiplier states that, if there is any change in government spending or government tax revenue of the economy, it will cause to change in the GDP in a higher portion than the initial injection. So, the portion of changing GDP is determined by the size of the fiscal multiplier. Fiscal multiplier size formula is as follows.

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Fiscal multiplier formula

Change in GDP = Fiscal multiplier X Change in injections

Fiscal multiplier example 1

As example, if the Fiscal multiplier is 2 and government expenditure is increased by $50 billion, GDP will be increased by $100 billion.

Change in GDP = Fiscal multiplier X Change in injections

So, Change in GDP = 2 X $50 billion = $100 billion

When we don’t know the change in government spending or tax and change in GDP, we can determine fiscal multiplier as follows

How to calculate fiscal multiplier?

What is the formula of multiplier and MPC? To determine fiscal multiplier, we should have mpc or mps and thn we can use the following fiscal multiplier equation.

multiplier effect formula

Fiscal multiplier size

So, the size of the fiscal multiplier depends on the marginal propensity to consume (MPC) and the marginal propensity to save (MPS). Let’s consider them.

Marginal Propensity to Consume (MPC)

Marginal propensity to consume means how much total consumption is changed because of the change in consumer income. It can be presented as a formula as follows.

Marginal Propensity to Consume = Change in consumption (ΔC) / Change in income (ΔY)

Marginal Propensity to Save (MPS)

Marginal propensity to save means how much total private savings is changed because of the change in consumer income. It can be presented as a formula as follows.

Marginal Propensity to Save = Change in savings (ΔS) / Change in income (ΔY)

Let’s calculate the fiscal multiplier of an economy

How to calculate fiscal multiplier with example?

Fiscal multiplier example 2

Let’s assume that consumer income is increased by $1000 and as a result of it, consumption is increased by $750. So, let’s Calculate the MPC.

Marginal Propensity to Consume = Change in consumption (ΔC) / Change in income (ΔY)

Marginal Propensity to Consume = 750/1000 = 0.75

MPC is 0.75. That means when consumer income is increased by a $1, consumption is increased by $0.75.

So, let’s calculate the fiscal multiplier of the economy

fiscal multiplier (k) = 1 / (1 – MPC) = 1 / (1 – 0.75) = 4

Therefore, it means that every $1 of new income will generate $4 of extra income.

Fiscal multiplier example 3

Let’s assume that consumer income is increased by $1000 and as a result of it, savings is increased by $250. Calculate the MPS.

Marginal Propensity to Save = Change in savings (ΔS) / Change in income (ΔY)

Marginal Propensity to Save = 250/1000 = 0.25

MPS is 0.25. That means when consumer income is increased by a $1, savings is increased by $0.25.

So, let’s calculate the fiscal multiplier of the economy

Fiscal multiplier (k) = 1 / (1 – MPC) = 1 / 0.25 = 4

It means that every $1 of new income will generate $4 of extra income.

If the fiscal multiplier is 4 and government expenditure is increased by $50 billion, GDP will be increased by $200 billion.

Change in GDP = fiscal multiplier X Change in injections

Change in GDP = 4 X $50 billion = $200

Multiplier effect graph in economics

According to the fiscal multiplier, when government expenses and tax are changed, they will lead some multiple of the increase or decrease of output level.

multiplier effect diagram

According to above graph, aggregate demand of an economy will shift to the right by a small portion after the initial inject ( equals to the government expenditure increase or tax cut amount). After that, aggregate demand will rise in multiple times as graphed in the above diagram.

Negative multiplier effect

Multiplier effect does not only work for the positive side but also it works for the negative side. So, negative multiplier effect can calculate how much is the decreasing of final GDP as results of the initial change in injections or withdrawals.

Negative fiscal multiplier effect occurs as results of the decrease of the government expenditure and rise of the tax.

Fiscal multipliers in recession and expansion

1. How does an economy get out of a recession?

Assume that an economy is experiencing in a recession. So, the government should apply the expansionary fiscal policy (increase expenses and cut taxes) to recover the economy. The recessionary gap is $1000. MPC is 0.8. How much will the government have to increase spending in order to close the recessionary gap?

Fiscal multiplier (k) = 1 / (1 – MPC) = 1 / (1 – 0.8) = 5

Change in GDP              = Fiscal multiplier X Change in government expenditure

1000                               = 5 X Change in government expenditure

1000/5                            = Change in government expenditure

Change in government expenditure /tax    = $200

Therefore, the government has to increase spending by $200

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2. How does an economy get out of an inflation?

Assume that an economy is experiencing in inflation. So, the government should apply the contractionary fiscal policy (cut expenses and increase taxes) to recover the economy. The inflationary gap is $1500. MPC is 0.6. How much will the government have to decrease spending in order to close the inflationary gap?

Fiscal multiplier (k) = 1 / (1 – MPC) = 1 / (1 – 0.6) = 2.5

Change in GDP              = Fiscal multiplier X Change in government expenditure

-1500                              = 2.5 X Change in government expenditure

-1500/2.5                       = Change in government expenditure

Change in government expenditure    = -$600

Therefore, the government has to decrease spending by $600

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