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Keynesian multiplier

The concept of multiplier was first of all


developed by F.A. Kahn in the early
1930s. But Keynes later further refined it.
In economics, a multiplier is the factor by
which gains in total output are greater
than the change in spending that caused
it.
KEYNESIAN MULTIPLIER
EFFECTS
KEYNESIAN MULTIPLIER
EFFECTS

Lets say you find a dollar in the street.


You now have one dollar you did not
have before. You now have an income
of one dollar. What can you do with
that dollar?? You can spend all of it,
save all of it, or spend some of it and
save some of it. You have options!
KEYNESIAN MULTIPLIER
EFFECTS

Lets assume you decide to spend the


WHOLE dollar. Your spending of that dollar is
an EXPENDITURE for you and INCOME for
the person (entrepreneur) you traded with.
KEYNESIAN MULTIPLIER
EFFECTS

How much did GDP increase with this


transaction?

$1.00

(you bought stuff)


KEYNESIAN MULTIPLIER
EFFECTS

Now what happens to that dollar in the


possession of the entrepreneur? They
have the same options you had:

Spend it or Save it.


KEYNESIAN MULTIPLIER
EFFECTS

Lets assume the entrepreneur spends


the WHOLE dollar at another business.

This expenditure for the entrepreneur is


now INCOME for another entrepreneur.
KEYNESIAN MULTIPLIER
EFFECTS

How much did GDP increase with this


transaction?

$1.00

Does this sound familiar??


KEYNESIAN MULTIPLIER
EFFECTS

This found dollar has now purchased


$2.00 worth of goods and/or services.

The original dollar appears to be cloning


itself!!
KEYNESIAN MULTIPLIER
EFFECTS

If we repeat this pattern, it would go on


FOREVER and GDP would increase
INFINITLEY. Is this possible?
UnlikelyWhy?
KEYNESIAN MULTIPLIER
EFFECTS

People have a TENDENCY TO SAVE some


portion of each dollar they receive.

Keynes had a fancy name for this: Marginal


Propensity to Save (MPS). In laymans
terms this means people have a TENDENCY
TO SAVE A PORTION OF EACH
ADDITIONAL DOLLAR they receive.
KEYNESIAN MULTIPLIER
EFFECTS

The flip side of this is people have a


TENDENCY TO SPEND (or CONSUME)
some portion of each dollar they receive.

Keynes had a fancy name for this: Marginal


Propensity to Consume (MPC). In laymans
terms this means people have a TENDENCY
TO CONSUME A PORTION OF EACH
ADDITIONAL DOLLAR they receive.
KEYNESIAN MULTIPLIER
EFFECTS

Example: If I get an additional dollar I


may consume .90 and save .10.
My Marginal Propensity to Consume
(MPC) that dollar is then: 90%.
My Marginal Propensity to Save (MPS)
that dollar is then: 10%.
KEYNESIAN MULTIPLIER
EFFECTS

Example: If I get an additional dollar I


may consume .90 and save .10.
My Marginal Propensity to Consume
(MPC) is then: 90%.
My Marginal Propensity to Save (MPS) is
then: 10%.
KEYNESIAN MULTIPLIER
EFFECTS

Do you notice a pattern?

MPC + MPS = 1.00 (or 100%)


KEYNESIAN MULTIPLIER
EFFECTS

Lets see how this works in practice.


Assume the Government wants to increase
their spending by $10 billion dollars. Assume
that the MPC in the economy is 90% and the
MPS is 10% (remember these must equal
100%). What is going to be the effect on the
GDP when we consider the Multiplier effect of
EACH of those dollars?
KEYNESIAN MULTIPLIER
EFFECTS
The Government initially spends $10
billion in the economy to purchase goods
and services. Does the Government
SAVE any of this money? NO.
What is the immediate effect of this
transaction on GDP? It INCREASES by
$10 billion.
KEYNESIAN MULTIPLIER
EFFECTS

What is now going to happen to that $10


billion now in the hands of people in the
economy? Keynes says that people in
general will spend 90% of it and save
10%.
So when people spend 90% of $10
billion, how much is GDP going to
increase by? $9 billion.
KEYNESIAN MULTIPLIER
EFFECTS

With these initial two transactions, how


much has GDP increase by?

$10B + 9B = 19B

Once again the original $10B has


magically turned into $19B in GDP .
KEYNESIAN MULTIPLIER
EFFECTS

Now when people who receive the $9B, they are going
to spend 90%, or $8.1B and save 10%, or $900 Million.

GDP is now growing again!

$10B + $9B + $8.1B = $27.1 Billion

It does not stop here. Each time the money is


spent it keeps reducing by the 90% and 10%
ratio UNTIL it gets to ZERO and GDP is some
much larger number.
KEYNESIAN MULTIPLIER
EFFECTS
Do you want to do all that math to arrive
at how much GDP is going to increase in
the end. I did not think so.
Keynes came up with a simple formula to
do the math for you. Remember in the
beginning it was GOVERNMENT that
started this.
This is very IMPORTANT to remember.
KEYNESIAN MULTIPLIER
EFFECTS

The Keynesian Government Spending Multiplier


is 1/MPS. WOW that will be hard to remember!
Lets use the information we have already been given:
The MPC is 90% and the MPS is 10%.
We can plug the appropriate number into the
Government Spending Multiplier and come up with a
useful number.
Govt. Spending Multiplier =
1/MPS = 1/10% = 1/.10 = 10
KEYNESIAN MULTIPLIER
EFFECTS

Now this is AMAZING! According to KEYNES when government spends a


dollar in the economy it is going to purchase a multiple of 10 times itself in
GDP.

If Government increases spending by 10 Billion, then the eventual impact on


GDP is going to be an increase of:

$10 Billion X 10 = $100 Billion

NOTE: This works in REVERSE as well. If Government DECREASES


spending by $10 Billion, it will serve to DECREASE GDP by a multiple of 10!
KEYNESIAN MULTIPLIER
EFFECTS

SUBTLETY ALERT!!
Notice in the VERY FIRST round of spending by the Government
that NOTHING is SAVED. The economy has the benefit of the
FULL impact of the $10Billion in new spending. In subsequent
rounds of spending people are saving a portion of the money
they receive, therefore REDUCING the impact on the economy.
When we do the TAX CUT MULTIPLIER next, this distinction
will be important. It forms the foundation of why Keynes
suggested that in times of severe economic crisis it should be
the role of Government to be active in the economy.
KEYNESIAN MULTIPLIER
EFFECTS

TAX CUT MULTIPLIER

Instead of Government
changing its spending, they
could change TAXES instead.
KEYNESIAN MULTIPLIER
EFFECTS

Assume in the economy the MPC and the


MPS are still 90% and 10% respectively.
Assume the Government decides to REDUCE
taxes by $10 Billion. This means that $10B
is now in the hands of people and NOT in the
hands of the Government. According to
Keynes, what is the first thing that people in
the economy are going to do with that new
$10Billion?? They are going to Spend 90%
and Save 10%!!
KEYNESIAN MULTIPLIER
EFFECTS

When they spend 90% it is going to


INCREASE GDP by $9Billion in the
FIRST ROUND of Spending (how does
that compare when in the previous
example Government spent FIRST).
This transaction INCREASED GDP by
$9B.
KEYNESIAN MULTIPLIER
EFFECTS

The people who receive the $9B are


going to SPEND 90%, or $8.1Billion and
SAVE $900 Million.
This transaction will INCREASE GDP by
$8.1Billion.

GDP is now $9B + $8.1B =


$17.1Billion.
KEYNESIAN MULTIPLIER
EFFECTS

The people who receive the $8.1Billion are going to SPEND 90%,
or $7.290 Billion and SAVE 10%, or $810 Million

This transaction will INCREASE GDP by $7.290 Billion.

GDP is now $9B + $8.1B + 7.29B = 24.390Billion.

Once again, it does not stop here. Each time the money is spent
it keeps reducing by the 90% and 10% ratio UNTIL it gets to
ZERO and GDP is some much larger number.
KEYNESIAN MULTIPLIER
EFFECTS

Keynes came up with a simple formula to do


the math for you. Remember in the beginning
it was PEOPLE in the Economy that start this.
This is very IMPORTANT to remember.

The KEYNESIAN TAX CUT MULTIPLIER = -MPC/MPS.

WOW that will be hard to remember!


KEYNESIAN MULTIPLIER
EFFECTS

Example:
We know the MPC is 90% and the MPS is 10%.
We can plug the appropriate number into the Tax Cut
Multiplier and come up with a useful number.
Tax Cut Multiplier

-MPC/MPS = 90%/10% = .-,90/.10 = -9


KEYNESIAN MULTIPLIER
EFFECTS

According to Keynes if the Government REDUCED


TAXES (-) and you multiply by the TAX CUT
MULTIPLIER, that is how much GDP will
INCREASE.

In our example, the Government DECREASED taxes


by 10Billion (-) and you multiply this by the tax cut
multiplier of -9, then GDP will eventually INCREASE
(two negatives make a positive) by $90Billion.
NOTE: This works in REVERSE. If Government INCREASE TAXES by
$10Billion then this will serve to DECREASE GDP by a multiple of 9.
(+10billion X -9 = -90Billion).
KEYNESIAN MULTIPLIER
EFFECTS
NOT SO SUBTLE ALERT!!!

Do you notice the different effects of the Government Spending


Multiplier and the Tax Cut Multiplier? The Government Spending
Multiplier appears to ALWAYS come out ahead of the Tax Cut
Multiplier in terms of how much GDP is eventually impacted.

THIS IS THE POINT Of THESE KEYNESIAN MULTIPLIERS!!


According to Keynes, INCREASED Government spending
outperforms DECREASES in Taxes to stimulate (prime the
pump) the economy.
KEYNESIAN MULTIPLIER
EFFECTS
Lets put these Keynesian Multipliers together
and see how it all washes out
Assume the Government wants to do the right
thing when they INCREASE Government
spending they ALSO INCREASE Taxes to pay
for it, so they wont have to borrow to pay for
the spending. Novel idea, I know, but it could
happenNOT!
KEYNESIAN MULTIPLIER
EFFECTS
Assume Government want to INCREASE
spending by $20 Billion and the MPC is
80% and the MPS is 20%. If they dont
want to create a budget deficit they must
INCREASE Taxes by $20 Billion to pay
for the new spending.
What is going to be the NET EFFECT of
this action on the Economy?
KEYNESIAN MULTIPLIER
EFFECTS
Calculate the Government Spending
Multiplier (1/MPS = 1/20% = 1/.20 =
5)
If government spending INCREASES
by $20B and the multiplier is 5 then,
GDP is going to INCREASE by $100B
($20B X 5 = $100B).
KEYNESIAN MULTIPLIER
EFFECTS
This is only half the storyNow we have to take $20B
OUT of the Economy in TAXES to pay for the new
spending.
Calculate the TAX CUT MULTIPLIER
(-MPC/MPS = -80%/20%=-.80/.20 = -4)
If TAXES are INCREASED by $20B and the tax cut
multiplier is -4 then GDP is going to DECREASE by
$80B ( +20B X -4 = -80B)
The multiplier effect is working in REVERSE to
DECREASE GDP by a multiple of 4!
KEYNESIAN MULTIPLIER
EFFECTS

What is the NET EFFECT after the TWO MULTIPLIERS do


their work?
The INCREASED Government Spending has
INCREASED the GDP by $100B
The Tax INCREASE has DECREASED the GDP by -80B.
BOTTON LINE: GDP (AGGREGATE DEMAND) has
INCREASED by $20B!! The Miracle of the Keynesian
Multiplier

NOTE: This works in REVERSE as well. If Government Spending DECREASED by


$20B and DECREASED Taxes by $20B, then the NET EFFECT on the Economy will
be a Net DECREASE in GDP of -$20B. THE HORRORS!!
KEYNESIAN MULTIPLIER
EFFECTS

Think about this: Government


INCRESED spending by $20B and
INCREASED Taxes by $20B to pay for
the spending and the economy came
out AHEAD by $20B in INCREASED
GDP. Notice a pattern??
KEYNESIAN MULTIPLIER
EFFECTS
NOT SO SUBTLE ALERT:

Pick any dollar amount that Government could


increase it spending by and increase taxes by
the SAME amount to maintain a BALANCED
BUDGET. The result will be an INCREASE in
GDP by the SAME amount that you increased
spending and increased taxes. Cool, huh!!
KEYNESIAN MULTIPLIER
EFFECTS
Keynes called this the BALANCED BUDGET
MULTIPLIER

The BALANCED BUDGET MULTIPLIER is 1


Take whatever you INCREASE Government
Spending and INCREASE Taxes by and
Multiply by 1 you will get what the NET
INCREASE is in GDP.

Note: THIS WORKS IN REVERSE AS WELL


KEYNESIAN MULTIPLIER
EFFECTS
Lets Do Some Examples
Assume we can determine there is a
recessionary gap in the Economy of $100
Billion.
Assume the MPC is 75% and the MPS is 25%
If the Govt. decides to change spending,
would they INCREASE or DECREASE
spending? By How Much?
KEYNESIAN MULTIPLIER
EFFECTS
Determine the Govt. Multiplier.

1/MPS = 1/25% = 1/.25 = 4

This means that ANY dollar the Govt spends in the economy is
going to multiply on itself 4 TIMES

The Recessionary Gap is $100B

$100/4 = $25 Billion

This is the amount Govt. would INCREASE spending to close


this $100B gap (move closer to Full-Employment)
KEYNESIAN MULTIPLIER
EFFECTS
Assume we can determine there is a
recessionary gap in the Economy of
$100 Billion.
Assume the MPC is 75% and the MPS is
25%
If the Govt. decides to change TAXES
would they INCREASE or DECREASE
Taxes? By How Much?
KEYNESIAN MULTIPLIER
EFFECTS
Determine the TAX CUT MULTIPLIER.

-MPC/MPS = -75%/25% = -.75/.25 = -3

This means that ANY dollar received in Tax Cuts in the economy is
going to multiply on itself 3 TIMES

The Recessionary Gap is $100B

$100/-3 = -$33.33 Billion


(-$33B X -3 = $100B)

This is the amount Govt. would DECREASE TAXES by to close


this$100B gap (move closer to Full-Employment)
Autonomous and induced
spending

Autonomous spending is not caused by a change in income. Autonomous


expenditure is independent of the level of GDP.

Induced expenditure is caused by change in income. As real GDP goes up,


induced expenditure increases and vice versa.

In general, a change in autonomous expenditure creates a change in RGDP,


which in turn creates a change in induced expenditure.

The multiplier effect can only be initiated by a change in autonomous


expenditure. Since the economy is in equilibrium, it is impossible for RGDP to
change unless something acts upon it from outside the system.
MULTIPLIER & AD and RGDP
Effect of multiplier in relation
to the price level
In order to receive the maximum
possible effect of multiplier on RGDP, it
is necessary that the price level is
constant.
As per monetarist model, increase
in AD always lead to increase in PL but
Multiplier is based on Keynesian
thinking, according to which the point
that when an economy is in a
recessionary gap, unemployed
resources and spare capacity allow AD
to increase without putting upward
pressure on the PL. In this situation,
any autonomous increase in spending
leads to a substantial larger increase
in real GDP.
Few numerical questions to
solve
1. What is the value of the tax multiplier if the MPC is 0.80? _____________________________________

2. What is the value of the government spending multiplier if the MPC is 0.67? ____________________________

3. What is the tax multiplier if the MPS is 0.25? ________________________________

4. Assume that in an economy MPM = 0.1, MPS = 0.2


and taxes are given by the equation T = 0.2Y. If the
equilibrium level of national income is originally at $85
billion and exports shrink by $ 4 billion, calculate the
new level of equilibrium income.
Few numerical questions to
solve
5. In an economy the government is planning to spend
an extra $200 billion. What will national income be
equal to if the marginal propensity to withdraw is 0.59
and current equilibrium income is $1.2 trillion?

6. An economy has a MPC of 0.50, calculate the


amount of injections that would be needed to increase
national income by $20,000,000.
Few numerical questions to
solve
7. Assume that current real gross domestic product falls short of full-employment output by $500 billion and the MPC is 0.8.

i. Calculate the minimum increase in govt. spending that could bring about full employment.

k = 1/1-0.8 = 1/ 0.2 = 5
Required Change in G = desired Change in AD/k = 500b/5 = Increase in govt. spending $100b

ii. Assume that instead of increasing govt. spending, the government decides to reduce personal income taxes. Will the
reduction in personal income taxes required to achieve full employment be larger than or smaller than the govt. spending
change you calculated in part i. Explain why.

T = -MPC/MPS = -0.8/0.2 = -4
Needed change in tax = desired change in AD/-t (desired tax multiplier) =500b/-4 = -125
Tax must fall by $125b