Keynesian Multiplier and Fiscal Policy Effects
Keynesian Multiplier Effect
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, which also increases agents’ disposable income in the economy. In turn, these revenues are used to finance consumer demand and investment, leading to a further increase in production, which generates more income, and so on. Multiplier:
Conclusion 1: Haavelmo Theorem
An increase in government spending leads to higher growth in aggregate demand than you would get from a tax cut of the same amount. The reason for this difference is that while spending contributes entirely to aggregate demand, a tax reduction does not immediately increase demand because not all disposable income of the operators will be consumed. The amount of this leakage will be greater the lower the propensity to consume and the greater the propensity to save among families. The increased production is exactly equal to public spending. This is the Tº Haavelmo.
Conclusion: Ripple Effect of Public Spending
An increase in public spending has a ripple effect on economic activity, even if it is funded entirely with tax increases (i.e., even if a balanced budget is sought). According to the Keynesian view, the deficit caused by increases in public spending will be temporary, as the economic recovery will lead to new tax revenues that will absorb the excess spending.
Failure of Automatic Stabilizers
We call those components of the budget automatic stabilizers that have a cyclical effect on economic activity, regardless of discretionary fiscal policy. Taxes and transfers are the largest budget items for stabilizing power.
- In times of recession, as activity declines, revenues are reduced, and at the same time, expenditure on transfers such as unemployment benefits, subsidies, etc., increases.
- Such transfers limit the fall in household disposable income and businesses, thus cushioning the decline in demand for consumer goods and gross capital formation.
- In the expansion phase, the budget tends to show a surplus. Disposable income increases less than national income, which helps to contain demand pressures and the risk of inflation.
However, the play of automatic stabilizers is not sufficient to cushion the cycle entirely. The intensity or speed of response of the stabilizers are not sufficient to ensure stable economic growth.
Automatic vs. Discretionary Policy
It must be kept in mind that stabilization policy aims for internal balance, not budget balance. The budget is a tool used to maintain non-inflationary growth of output and employment; for that, one sometimes must record a deficit, sometimes a surplus, and other times it is desirable to balance the budget.
Cyclical Deficit
This is a deficit estimated from the comparison between the growth path corresponding to real economic activity that would correspond with the deficit and the evolution of the production of internal balance.
Discretionary or Structural Deficit
This deficit is due to discretionary income and expenditure that would correspond to a situation of internal balance.