Fiscal Multiplier

As a part of its expansionary fiscal policy, when the government of a country decides to increase spending, it has a multiplier effect on the aggregate demand, i.e., the aggregate demand increases much more than the actual increase in spending.

The actual increase in the aggregate demand depends on the tax rate (again set by the government), and the marginal propensity to consume (MCP), i.e., how much will the consumption increase with an increase in disposable income.

Let’s take a simple example to understand this multiplier effect. Assume that the government increases its spending by $100. Assume that the tax rate and MCP for those who receive this money is 30% and 90%. So, a $100 increase in government spending increases income by $100*(1-0.30) = $70. From this disposable income of $70, people will spend $70 *0.90 = $63. This $63 will become income for other people, and their disposable income will be $63*(1-0.30) = $44.1, out of which they will spend $44.1*0.90 =  $39.69. This process will continue till the additionally created disposable income becomes close to zero.

The actual increase in aggregate demand due to increased spending can be calculated using the fiscal multiplier.

Fiscal Multiplier = 1/(1-MCP(1-t))

Where, t is the tax rate.

With t = 30% and MCP = 90%, the Fiscal multiplier will be:

Fiscal multiplier = 1/(1-0.90*(1-0.30)) = 2.7