Download keynesian multiplier effects

KEYNESIAN MULTIPLIER
EFFECTS
Let’s 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
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Let’s 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
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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
Let’s 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?
Unlikely…Why?
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 layman’s
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
layman’s terms this means people have a
TENDENCY TO CONSUME A PORTION OF
EACH ADDITIONAL DOLLAR they receive.
KEYNESIAN MULTIPLIER
EFFECTS
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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
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Example: If I get an additional dollar I
may consume .80 and save .20.
My Marginal Propensity to Consume
(MPC) is then: 80%.
My Marginal Propensity to Save (MPS) is
then: 20%.
KEYNESIAN MULTIPLIER
EFFECTS
Do you notice a pattern?
MPC + MPS = 1.00 (or 100%)
KEYNESIAN MULTIPLIER
EFFECTS
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Let’s 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. They spend the whole shebang!
What is the immediate effect of this
transaction on GDP? It INCREASES by
$10 billion.
KEYNESIAN MULTIPLIER
EFFECTS
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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
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With these initial two transactions, how
much has GDP increase by?
$10B + 9B = 19B
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Once again the original $10B has
“magically” turned into $19B in GDP .
KEYNESIAN MULTIPLIER
EFFECTS
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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
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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 buying frenzy. This is
very IMPORTANT to remember.
KEYNESIAN MULTIPLIER
EFFECTS
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The Keynesian Government Spending Multiplier
is 1/MPS.
Let’s 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

According to KEYNES when government spends a dollar in the economy it
is going to purchase a multiple of 10 times itself in GDP.
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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
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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
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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
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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
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The people who receive the $8.1Billion are going to SPEND
90%, or $7.290 Billion and SAVE 10%, or $810 Million
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This transaction will INCREASE GDP by $7.290 Billion.
GDP is now $9B + $8.1B + 7.29B = 24.390Billion.
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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 buying frenzy. This is very
IMPORTANT to remember.
The KEYNESIAN TAX CUT MULTIPLIER =
-MPC/MPS.
KEYNESIAN MULTIPLIER
EFFECTS
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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.
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Tax Cut Multiplier
-MPC/MPS = 90%/10% = .-,90/.10 = -9
KEYNESIAN MULTIPLIER
EFFECTS
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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
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Let’s 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 won’t have to
borrow to pay for the spending. Novel idea, I
know, but it could happen…NOT!
KEYNESIAN MULTIPLIER
EFFECTS
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Assume Government want to
INCREASE spending by $20 Billion and
the MPC is 80% and the MPS is 20%.
If they don’t 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
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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
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This is only half the story…Now 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
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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.
KEYNESIAN MULTIPLIER
EFFECTS
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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
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Let’s 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
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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
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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
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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)