Keynesian Multiplier Effects

KEYNESIAN MULTIPLIER EFFECTS
Lets 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!
Lets 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.

How much did GDP increase with this transaction?
$1.00
(you bought stuff)
Now what happens to that dollar in the possession of the entrepreneur? They have the same options you had: Spend it or Save it.

Lets assume the entrepreneur spends the WHOLE dollar at another business.
This expenditure for the entrepreneur is now INCOME for another entrepreneur.

How much did GDP increase with this transaction?
$1.00
Does this sound familiar??

This found dollar has now purchased $2.00 worth of goods and/or services.
The original dollar appears to be cloning itself!!

If we repeat this pattern, it would go on FOREVER and GDP would increase INFINITLEY. Is this possible? UnlikelyWhy?

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 laymans terms this means people have a TENDENCY TO SAVE A PORTION OF EACH ADDITIONAL DOLLAR they receive.

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 laymans terms this means people have a TENDENCY TO CONSUME A PORTION OF EACH ADDITIONAL DOLLAR they receive.
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%.
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%.

Do you notice a pattern?
MPC + MPS = 1.00 (or 100%)

Lets 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?
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.
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.
With these initial two transactions, how much has GDP increase by?
$10B + 9B = 19B
Once again the original $10B has magically turned into $19B in GDP .
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.
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.
The Keynesian Government Spending Multiplier is 1/MPS. WOW that will be hard to remember! Lets 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
Now this is AMAZING! According to KEYNES when government spends a dollar in the economy it is going to purchase a multiple of 10 times itself in GDP.
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!

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.
TAX CUT MULTIPLIER
Instead of Government changing its spending, they could change TAXES instead.
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%!!
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.
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.
The people who receive the $8.1Billion are going to SPEND 90%, or $7.290 Billion and SAVE 10%, or $810 Million This transaction will INCREASE GDP by $7.290 Billion.
GDP is now $9B + $8.1B + 7.29B = 24.390Billion.
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.
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.
WOW that will be hard to remember!

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.
Tax Cut Multiplier
-MPC/MPS = 90%/10% = .-,90/.10 = -9
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).

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.
Lets 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 wont have to borrow to pay for the spending. Novel idea, I know, but it could happenNOT!
Assume Government want to INCREASE spending by $20 Billion and the MPC is 80% and the MPS is 20%. If they dont 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?
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).
This is only half the storyNow 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!
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!!

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??

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. Cool, huh!!
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

Lets 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?
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)
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?
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)

Keynesian Multiplier Effects

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KEYNESIAN MULTIPLIER EFFECTS