The size of the multiplier varies significantly amongst countries.

Explain why some countries have relatively smaller multiplier values than others and assess the extent to which the estimated multiplier value is useful in forecasting the impact of an expansionary fiscal policy on an economy. [25]

Introduction

Fiscal Policy is a macroeconomic policy in which the government budget is manipulated, through adjusting government expenditure or tax rates, in order to achieve macroeconomic objectives of an economy.

The formula of the multiplier is given by 1/marginal propensity to withdraw (1/mpw), thus, the value of the multiplier is inversely proportional to the marginal propensity to withdraw.

Marginal propensity to withdraw is made up of

1.    marginal propensity to save (MPS)

2.    marginal propensity to tax (MPT)

3.    marginal propensity to import (MPM)

WHY SOME COUNTRIES HAVE RELATIVELY SMALLER MULTIPLIER VALUES THAN OTHERS

·       Explain how countries can differ in the above

1. MPS (depends on culture and government policy, e.g. U.S. vs China/Singapore)

2. MPT (depends on tax policies, low tax rates (Switzerland/Singapore) vs high tax rates (Australia)

3. MPM (depends no nature of economy, e.g. Singapore vs Australia)

·       Countries with high MPW values due to the respectively high MPS, MPT and MPM values will therefore have a smaller multiplier value.

HOW THE ESTIMATED MULTIPLIER VALUE IS USEFUL TO PREDICT THE IMPACT OF A RISE IN GOVERNMENT SPENDING ON AN ECONOMY

·       Explain the multiplier process

Ø  Suppose the economy is at an equilibrium position and then government spending increases by $1m due to an increase in the government purchase of say infrastructural goods priced at $1m.

Ø  The people who produced these infrastructural goods receive an extra $1m in income. Thus, income rises by $1m in the first round. 

Ø  The people who produced these goods will spend some of the increase in their income and withdraw some of it in the form of saving, taxes and imports. Because one person’s expenditure is another’s income, income will rise again. Thus, if the MPC is ¾, the group that produced these infrastructural goods will spend $750,000 on goods and services and will withdraw $250,000. 

Ø  The $750,000 spent becomes income for the people who produced the $750,000 worth of consumer goods. The process will not stop here. The people who just receive an increase in income of $750,000 will spend some and withdraw some. The amount they spend becomes income for others. 

Ø  This process only stops when the total withdrawals is equal to the initial increase in expenditure. The total increase in national income will be increase in I ×k, where k = 1/(1 – MPC), which is 4 in this case. Hence total increase in Y = $4m. 

Ø  Thus, an increase in government spending (or any components of AD) will lead to a rise in national income, but whether real output or prices will rise depends on whether the economy is at below or at full employment level. Theoretically, based on the multiplier process, an increase in the government expenditure by $10m for example, will lead to a corresponding increase in national income by $10m ×k, where k is the multiplier value. 

HOW THE MULTIPLIER VALUE ALONE MAY NOT BE USEFUL

·       The impact depends on the nature of the government spending. If a large part of government spending goes towards imports (military spending could go towards the acquisition of imported weapons and equipment like fighter jets and submarines, infrastructural spending could include the need to import large quantities of raw materials), it could cause a worsening trade deficit as import expenditure rises. This will not have a positive impact on the economy.

·       Presence of crowding out effect. 

Ø  Government expenditure could crowd out private investments. This is especially so if the government has to resort to borrowing to fund its expenditure if it already has persistently huge deficits. The increased borrowing will result in the competition for loanable funds and raising interest rates. 

Ø  Higher interest rates will lead to lower level of investments. If government expenditure rises but investment spending falls – the net positive impact of the increase in government expenditure may not be significant.

Conclusion

The value of the multiplier, no doubt, can help us predict the impact of an expansionary fiscal policy on an economy, which is why the U.S. can adopt such policies with much success given its high multiplier value. However, other factors must be considered when a government plans such a policy, to ensure that the policy can achieve its intended purpose with minimal side effects.