Keynesian Multiplier and Fiscal Policy Effects
Keynesian Multiplier and Demand Changes
The idea of compensating changes in private demand with changes in public expenditure rests on the Keynesian Multiplier. An increase in public spending increases domestic production and, consequently, agents’ disposable income. In turn, these increased incomes finance consumer demand and investment, leading to a further increase in production, which generates more income, and so on.
Multiplier Conclusions
Conclusion 1: Haavelmo Theorem
An increase in government spending leads to higher growth in aggregate demand than a tax cut of the same amount would achieve. The reason for this difference is that while spending immediately becomes part of aggregate demand, a tax reduction is not initially fully translated into increased demand because not all disposable income will be consumed. The amount of this leakage is greater the lower the propensity to consume and the greater the propensity to save among families. The resulting increase in production is exactly equal to the initial public spending (The Haavelmo Theorem).
General Conclusion on Balanced Budget
An increase in public spending has a ripple effect on economic activity. Even if funded entirely by tax increases (a balanced budget approach), Keynesian theory suggests that any initial deficit caused by increased public spending will be temporary. Economic recovery will generate new tax revenues that will absorb the excess spending.
Failure of Automatic Stabilizers
We define automatic stabilizers as budget components that automatically exert a cyclical effect on economic activity, independent of discretionary fiscal policy. Taxes and transfers are the largest items contributing to this stabilizing power.
- In Recession: As activity declines, revenues decrease, and expenditures on transfers (like unemployment benefits and subsidies) increase. These transfers limit the fall in household and business disposable income, cushioning the decline in consumer demand and gross capital formation.
- In Expansion: The budget tends to move toward a surplus. Disposable income increases less than national income, which helps contain demand pressures and the risk of inflation.
However, the action of automatic stabilizers is often not sufficient to ensure stable economic growth; their intensity or speed of response may not be enough to fully cushion the economic cycle.
Automatic vs. Discretionary Policy
It must be remembered that stabilization policy aims for internal balance, not necessarily budget balance. The budget is a tool used to maintain non-inflationary growth of output and employment; therefore, it is sometimes necessary to record a deficit, sometimes a surplus, and other times aim for balance.
Key Deficit Types
Cyclical Deficit
This is a deficit estimated based on the difference between the actual growth path and the evolution of production that would correspond to internal balance.
Discretionary or Structural Deficit
This deficit results from discretionary income and expenditure decisions that would exist even in a situation of internal balance.