APMacro: Multiplier Effect

Because of the multiplier effect on changes in aggregate demand, the government does not have to fully fill a recessionary or inflationary gap with fiscal policy. The government can use the same multiplier in reverse. For example, if the multiplier is 4 and a $100 billion recessionary gap exists in the economy, government spending must only increase by $25 billion, which will eventually be multiplied by 4 to fully fill the gap.

It is important to note that changes in government spending and taxes have different levels of efficacy. While increases in government spending have a full multiplier effect because they are fully spent in the economy, reductions in taxes are less effective. Because the marginal propensity to consume is less than 1, households will choose to save part of a tax cut and spend the rest. As a result, the multiplier will be lower for a change in taxes than for a change in government spending. Therefore, government would have to change taxes by a greater amount than it would have to change spending, if it wants to achieve the same effect in the economy.



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