Part (a): Explaining the Keynesian multiplier
Key terms
An injection is an addition to the circular flow of income from outside the household-to-firm loop: investment, government spending or export earnings. The Keynesian multiplier is the ratio of the final change in real national income, or real output, to the initial change in an injection that caused it. It rests on two marginal propensities. The marginal propensity to consume, MPC, is the fraction of any extra income that households spend on domestic goods and services. The marginal propensity to save, MPS, is the fraction they save. More generally the marginal propensity to withdraw, MPW, is the fraction of extra income that leaks out of the domestic circular flow altogether, through saving, taxation and spending on imports.
How an injection raises output by more than itself
The multiplier works because one person's spending is another person's income. Suppose the government injects new spending by building a road. The construction firms and their workers receive that money as income. They do not save all of it; they spend a fraction of it, set by the MPC, on goods and services produced by other firms. Those firms and their workers now have higher incomes, and they in turn spend a fraction of the new income, and so on. Each round is smaller than the last, because at every stage some income leaks out to saving, tax and imports rather than being re-spent at home. The successive rounds form a converging series whose sum is a multiple of the original injection. Algebraically, the multiplier equals 1 divided by (1 minus MPC), which is the same as 1 divided by the marginal propensity to withdraw. If households re-spend four-fifths of extra income at home, so the MPC is 0.8 and the MPW is 0.2, the multiplier is 5, and an injection of 10 billion eventually raises real output by 50 billion. The smaller the leakages, the larger the multiplier; the bigger the MPC, the more each round adds.
The effect in the AD-AS model
In the aggregate demand and aggregate supply framework, the injection first shifts the AD curve to the right by the size of the initial spending, since government spending is a component of AD. The multiplier process then shifts AD further to the right, by the additional induced consumption of the later rounds, so the total rightward shift is a multiple of the original injection. With the price level on the vertical axis and real GDP on the horizontal axis, and an upward-sloping short-run aggregate supply curve, the new equilibrium sits at a higher level of real output. How much of the amplified AD shift becomes real output rather than a higher price level depends on how much spare capacity the economy has, an issue that matters greatly for part (b). With the long-run aggregate supply curve vertical at potential output, an economy already at capacity converts the extra demand into inflation rather than growth.
Part (b): Discussing the effectiveness of expansionary fiscal policy
Introduction
Expansionary fiscal policy is an increase in government spending or a cut in taxation aimed at raising aggregate demand. The multiplier is what makes it attractive: because the initial injection is re-spent in successive rounds, the policy can raise real output by more than the government itself spends. This part argues that expansionary fiscal policy can be highly effective in a deep recession with spare capacity, but that the size and even the direction of its effect depend on the marginal propensity to consume, the degree of crowding out, time lags and the sustainability of the resulting debt, so the multiplier should not be treated as an automatic guarantee of growth.
Why it can be highly effective
In a recession the case is strong. When output is well below potential, with idle factories and unemployed workers, the extra demand is met by putting those resources back to work rather than by raising prices, so most of the amplified AD shift becomes real output. The multiplier is also likely to be larger in a slump, because targeted spending and transfers to lower-income households, who have a high MPC, are re-spent rather than saved. This is the logic behind the coordinated fiscal stimulus after the 2008 financial crisis. Governments across the G20, including the United States with its 2009 Recovery Act, raised spending to arrest the collapse in private demand, and most subsequent estimates found multipliers above one when interest rates were near zero and slack was large, meaning each dollar of spending raised output by more than a dollar. Fiscal policy also has the advantage of being targetable: a government can direct spending at the regions, sectors or households where the need is greatest, which a general interest-rate cut cannot do.
Why the effect can be much smaller
The multiplier is not a free lunch. Its size falls as the marginal propensity to withdraw rises, so in an economy where households save heavily, taxes are high or imports take a large share of extra spending, much of each round leaks abroad or out of circulation and the multiplier is small. Crowding out is the central qualification: if the government borrows to fund the spending, the extra demand for loanable funds can push up interest rates and reduce private investment and consumption, offsetting part of the stimulus, an effect that is far stronger near full employment than in a deep slump. Time lags weaken it further, since recognising the downturn, legislating the spending and actually building the projects all take time, so the boost can arrive after the economy has already turned. And the policy is constrained by debt sustainability. Japan offers the cautionary example: decades of large fiscal stimulus from the 1990s onward, intended to lift the economy out of stagnation, delivered disappointing growth while pushing gross government debt above 200 percent of GDP, which shows that a high MPW, an ageing population that saves rather than spends, and mounting debt can blunt even sustained fiscal expansion.
Judgement
Expansionary fiscal policy, amplified by the multiplier, is at its most effective in a deep recession with ample spare capacity, near-zero interest rates and spending aimed at high-MPC households, where crowding out is weak and most of the amplified demand becomes real output, as the post-2008 stimulus broadly showed. It is much weaker, and can be largely offset, when the economy is near full employment, when the marginal propensity to withdraw is high, when borrowing crowds out private spending, or when debt is already so high that further stimulus is unsustainable, as Japan's experience warns. The supported judgement is that the multiplier makes fiscal policy a powerful counter-recessionary tool but not an automatic one: its effectiveness is conditional on the cyclical position, the structure of the economy and the room left in the public finances, so it should be judged case by case rather than assumed to work.