Fiscal policy and the multiplier
How government spending and taxes shift aggregate demand, why the multiplier and crowding out pull in opposite directions, and the debate over active stabilisation policy.
FinanceThe economy behind your investmentsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Calculate the spending multiplier from the marginal propensity to consume
- Explain the crowding-out effect
- Set out the arguments for and against active stabilisation policy
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The economy behind your investments: lesson 8 of 16
- The economy behind your investments
- Financial markets and intermediaries 5 min
- The market for loanable funds 5 min
- Banks and the money supply 5 min
- The quantity theory of money 5 min
- The aggregate-demand curve 5 min
- Monetary policy and aggregate demand 5 min
- Aggregate supply and the business cycle 5 min
- Fiscal policy and the multiplier 5 min
- The Phillips curve 5 min
- Expectations and the cost of lower inflation 5 min
- Rules or discretion 6 min
- Deficits and the case for balance 7 min
- Exchange rates and purchasing-power parity 5 min
- Exports, imports and capital flows 5 min
- The market for foreign-currency exchange 5 min
- Policies and shocks in an open economy 5 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 21
What it is
Fiscal policy is the government's choice of spending and taxes. Mankiw's example: the US Department of Defense places a 20 billion dollar order for fighter planes with Boeing. Aggregate demand shifts right, but by how much? Two effects pull in opposite directions.
The multiplier effect makes the shift bigger than 20 billion. Boeing's workers and owners earn more, so they spend more; the people they buy from earn more and spend more; and so on.
The marginal propensity to consume (MPC) is the share of extra income people spend. If the MPC is ¾, the 20 billion leads to 15 billion of extra spending, then 11.25 billion, and so on. Adding the rounds:
multiplier = 1 ÷ (1 − MPC)
With MPC ¾: 1 ÷ ¼ = 4, so 20 billion of purchases raises demand by 80 billion. With MPC ½, the multiplier is only 2. A larger MPC means a larger multiplier.
Quick check
Tap an answer to check it.
The MPC is 0.8. What is the multiplier?
- That is 1 ÷ 0.8; the multiplier is 1 ÷ (1 − MPC)
- That is the MPC itself
Show answer
5. 1 ÷ (1 − 0.8) = 1 ÷ 0.2 = 5.
Why it matters
The crowding-out effect makes the shift smaller. Higher income raises the demand for money, which pushes up interest rates (if the central bank holds the money supply fixed). Higher interest rates reduce investment, partly offsetting the extra government spending. The final shift may be more or less than 20 billion, depending on which effect is larger.
Taxes. A tax cut raises households' take-home pay, so they spend more, shifting aggregate demand right (with multiplier and crowding-out effects of its own). Mankiw notes that the size of the effect depends on whether people see the tax cut as permanent (large effect) or temporary (smaller effect).
Should policy try to stabilise the economy?
- For: Mankiw explains the case made since Keynes: when private spending falls, the government can offset it with monetary or fiscal policy, reducing recessions and unemployment. The US Employment Act of 1946 made promoting stable employment a federal responsibility.
- Against: some economists argue policy should aim at long-run goals, because policy works with long lags. Most economists believe changes in monetary policy take at least six months to affect spending; changes in fiscal policy must pass through a slow political process. Since forecasting is imprecise, a policy meant to help may arrive after the problem has passed, and make things worse.
- Automatic stabilisers need no decision: in a recession, tax revenue falls and spending on unemployment benefits and welfare rises automatically, cushioning demand.
Mankiw presents these as views held by different economists; the debate returns in Rules or discretion.
Worked example
The government spends an extra 50 (billion), and the MPC is 0.6.
- Multiplier: 1 ÷ (1 − 0.6) = 2.5.
- Shift in aggregate demand before crowding out: 50 × 2.5 = 125.
- First rounds: 50 + 30 + 18 + 10.8 + ... → 125.
- If crowding out reduces investment by 20 (as interest rates rise), the net shift is about 105.
Try other values:
Text description
Bar chart. Round 1 (government): 50; Round 2: 30; Round 3: 18; Round 4: 10.8; Round 5: 6.48.
Common mistake
Thinking a government spending increase always raises demand by exactly its own size, or always by the full multiplier. The multiplier pushes the effect up; crowding out pulls it down. The final effect depends on both, and on how the central bank responds.
Key terms
- fiscal policy
- the government's setting of spending and taxes
- marginal propensity to consume
- the share of extra income that people spend
- multiplier effect
- the extra shifts in aggregate demand when fiscal policy raises income and so raises spending
- crowding-out effect
- the offset to aggregate demand when expansionary fiscal policy raises interest rates and so reduces investment
- automatic stabilisers
- changes in taxes and spending that boost demand in a recession without deliberate action
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| fiscal policy | the government's setting of spending and taxes |
| marginal propensity to consume | the share of extra income that people spend |
| multiplier effect | the extra shifts in aggregate demand when fiscal policy raises income and so raises spending |
| crowding-out effect | the offset to aggregate demand when expansionary fiscal policy raises interest rates and so reduces investment |
| automatic stabilisers | changes in taxes and spending that boost demand in a recession without deliberate action |
Practice
Work it through
The government cuts its spending by 40, and the MPC is 0.75.
- 1 ÷ (1 − 0.75)
- 40 × 4
- 0.75 × 40
Quick quiz
Tap an answer to check it.
Why does the crowding-out effect occur?
- Mankiw's mechanism works through interest rates
Show answer
Higher income raises money demand and interest rates, which reduce investment. With a fixed money supply, more demand for money pushes rates up.
Which tax cut has the bigger effect on aggregate demand, in Mankiw's account?
- People spend less of a temporary rise in income
Show answer
One that people believe is permanent. A permanent cut raises expected income for years ahead.
What is an automatic stabiliser?
- That is deliberate policy
Show answer
Unemployment benefits that rise when a recession hits. Automatic stabilisers need no decision.
In short
- Multiplier = 1 ÷ (1 − MPC); a bigger MPC means a bigger multiplier.
- Crowding out works the other way, through higher interest rates.
- Tax cuts raise demand, more so if seen as permanent.
- Active stabilisation: some economists favour it; others worry about lags and forecasting. Automatic stabilisers work without decisions.
Mastery check
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Check yourself
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In Mankiw's example, how much does 20 billion of government purchases raise demand with an MPC of ¾, before crowding out?
Show answer
80 billion (a multiplier of 4).
What is the marginal propensity to consume?
Show answer
The share of extra income that households spend rather than save.
Why do some economists argue against active stabilisation policy?
Show answer
Policy works with long lags and forecasts are imprecise, so it may arrive too late and make fluctuations worse.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 21.
- On this site: Monetary policy and aggregate demand and The market for loanable funds.
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