Fiscal Multiplier

The fiscal multiplier measures how an initial change in government expenditure produces a larger or smaller change in equilibrium national income. The government expenditure multiplier is the ratio of the resulting change in output to the initial change in spending. Its size depends on how much additional income is repeatedly spent rather than withdrawn through leakages.

Transmission through the income-spending cycle

Government purchases enter aggregate demand directly through the government expenditure component. This initial demand injection becomes income for firms, workers and suppliers, who spend part of it according to their marginal propensity to consume.

• The induced consumption creates additional demand, production and income in successive rounds.
• Each round is smaller because households save part of additional income, while taxes and imports create further leakages.
• The process continues until cumulative leakages equal the initial expenditure injection.

Multiplier in the simple Keynesian model

In a closed economy with fixed prices and without induced taxes or imports, the expenditure multiplier is k = 1/(1-MPC) = 1/MPS. Thus, if government expenditure rises by ΔG, equilibrium output rises by ΔY = k × ΔG.

• A higher marginal propensity to consume strengthens successive spending rounds and increases the multiplier.
• Savings, taxation and imports reduce the multiplier because they withdraw purchasing power from the domestic income-spending stream.

Corporate investment and limits

Government capital expenditure can stimulate corporate investment by raising expected demand and providing infrastructure that lowers business costs. This crowding-in effect can reinforce the original multiplier through additional private investment and employment.

• The multiplier is generally stronger when unused capacity and unemployment allow output to expand without large price increases.
• It may weaken when borrowing raises interest rates and crowds out private investment, or when demand mainly raises prices and imports.
• The composition, financing and timing of expenditure therefore matter alongside its size.