MMTed - Home Page of Public Education in Modern Monetary Theory

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OK, now we've learnt that what drives output is spending and what drives employment is output. So spending drives output, which drives employment, which drives income.

And the important point is, let's think about a situation where the economy is in a position and the non-government sector, let's say households decide to save more.

Well, we've just learnt that that will disturb the position. And if that persists, the economy would go towards recession and that can be offset by government intervention in the form of increasing its, say, deficit.

Now, let's think about what the government needs to do if it wants to, say, increase employment by a certain proportion.

Well, the government needs to know two things.

First of all, has to design its intervention, how much it's going to spend and that depends upon a concept called the Expenditure Multiplier.

So this is another tool that you're learning, and it's not an unimportant tool because it becomes very significant in some of the big policy debates and scandals in in our more recent history.

So what's the expenditure multiplier? Well, here's the thing.

Let's say the government injects 100 extra dollars into the economy and you now know what that means.

And so what impact does that have on the economy?

Well, business firms get new orders for educational material or hospital supplies or whatever.

And they respond to that hundred dollars by producing an extra hundred dollars of output because spending drives output. And so in doing so, they have to hire extra workers and extra materials, and in doing that, that extra hundred dollars of output produces an extra hundred dollars of income initially.

Now, the workers that enjoy that extra employment, what are they going to do? Well, we know that their consumption spending depends upon income. And so they've now got jobs and they've now got higher incomes.

And so they go down after work to their local supermarket and down to the shop, their bar, they start spending the extra income.

Now, what does that do?

Well, that leads to an extra round of spending. And as a consequence, the workers have bought stuff in extra stuff in the supermarket or down the bar or gone to a sporting event or whatever.

And those producers of those goods and services then enjoy extra sales. And as a consequence, they employ more people and produce more income. So this is then becomes a sequential process.

And at each stage of that process, the extra spending boost is getting smaller and smaller, because at each stage of the process, there are the leakages we talked about. Because savings is a function of income. People have to pay more taxes because there's now more activity, not the tax rates have gone up. It's just that there's more people earning and tax revenue rises and also import rise.

And so at each stage of the cycle, each additional injection into the spending stream is getting smaller and smaller until it gets to zero.

And that's when we're back at a new equilibrium.

Now, the question is, what's the GDP at the end of that process in relation to the initial $100 injection of the government to stimulate the economy? Well, let's say it's $180.

Well then the expenditure multiplier is 1.8 and so now you understand what it means. It's the extra income or GDP that the economy will produce from a $1 injection into the spending stream that disturbs it.

Now, why is this important?

Well, let's think back to the Greek bailout in 2012 when the IMF, in conjunction with the European Commission, designed the so-called austerity program, which meant harsh cuts to government spending, which they told the Greek government and the rest of the world would actually end up producing more income. Now, what happened was that they imposed that austerity and the economy collapsed.

And later that year, the IMF was forced to put out a document apologising and admitting that in their modelling that led to the bailout package and the austerity, that they had made a mistake with the multiplier. And in actual fact, the multiplier was about 1.6 or something.

What does that mean?

That means that if they cut government spending by one euro, then overall economic GDP would drop by one point six euros. And so it was really easy to understand why the austerity destroyed their economy at that period. And so economists see the estimation of the expenditure multiplier as a very important thing to get right, and it's so susceptible to being miscalculated with devastating human consequences.

That's why you need to understand what the multiplier is and how it's used.

End of Transcript

Study Notes:

When governments are designing policy interventions that involve changes to expenditure, they want to have some idea of what impact an extra dollar of spending will have on output and employment. Otherwise, they would just be working in the dark. We have already learned that policy makers seek to exploit behavioural relationships that they consider to be congruent. The next task for them is to calibrate those relationships in numerical consequences.

The expenditure multiplier, which describes the GDP adjustment mechanism that occurs when an existing equilibrium is disturbed by a new spending injection (or withdrawal), is an essential part of the policy making tool kit because it answers the question as to how large an initial stimulus or contractionary package have to be to achieve the desired final outcomes. we have learned that that GDP and national income will rise if planned spending rises and will fall if planned spending falls. The question of interest now is by how much will GDP and national income change after a change in planned spending driven, for example, by a change in government spending.

You could think of this exercise as one where the government wants to create a certain number of jobs to get the economy back to full employment and knows that if output rises by some amount, that will lead firms to create the desired change in employment. So the government wants to know how large the initial stimulus has to be.

This is where the expenditure multiplier fits into the analysis. It describes a multi-period adjustment process following an initial change in spending.

From an initial equilibrium position, an increase in spending expenditure (say by government) provides an instant boost to total spending.

Firms respond to the increased planned expenditure and raise employment to produce the increased output or GDP. National income increases.

This rise in national income induces further consumption spending which leads to a further rise in aggregate spending, employment and GDP. A proportion of the rise in national income leaks out in the form of higher tax payments, import spending and increased saving.

So, after each 'round', the induced spending boost gets smaller and smaller.

The process continues until the induced spending becomes so small that there are no further GDP increases. On the other hand, a fall in autonomous expenditure leads to a series of cuts in employment, GDP and tax payments, imports and saving.

The expenditure multiplier thus indicates by how much GDP and national income changes when there is a change in autonomous expenditure. The larger is the multiplier, the larger is the change in GDP and national income for a given change in autonomous expenditure.

So, if the multiplier was 1.8, for example, then if the government increased its spending by $1, total GDP would rise by $1.80. If the multiplier was below 1, then a $1 increase in government spending, for example, would lead to less than $1 rise in GDP, which means a fiscal stimulus would fail.

This was the issue that arose in 2012 when the IMF designed the so-called Greek bailout, which was part of the Troika's plan (European Commission, European Central Bank, and the IMF) to cut the Greek government's fiscal deficit. They initially considered the multiplier was less than one, which meant that cutting government spending would be less damaging. After imposing very harsh austerity, the Greek economy collapsed and the decline in output was much larger than the initial cuts in spending, which meant that the actual multiplier was well in excess of one.

In fact, later in the year, the IMF admitted their estimates of the multiplier were wrong and they now considered the value to be around 1.7, which explains why the economy collapsed. The IMF was forced to apologise for their mistakes although that provided very little solace to the tens of thousands of people the IMF forced out of work and the collapse in public services as a result of the spending cuts imposed on the nation.

The point is that these concepts, though technical in construction, are not observed and have to be estimated. And the estimation process is dependent on starting assumptions about the factors that determine the value of the multiplier, which means the process can be manipulated to suit ideological biases.

Now reflect on your understanding of the income-expenditure framework to see if you can work out what factors will determine the size of the multiplier. Under what conditions will it be large?

2.14 The Expenditure Multiplier

Study Notes: