Recall from earlier lectures that real GDP increases by more than a given increase in household spending, investment, or government spending.
With an MPC estimated to be about 0.9 in the United States, the multiplier formula predicts the size of the simple spending multiplier to be about 10. (This is calculated by 1/(1-MPC) = 10.) For example, this would mean that a $1 billion increase in government spending would increase real GDP by $10 billion!
In reality, however, the size of the actual multiplier is estimated to be around 1.4. Why is the size of the actual multiplier so much less than that estimated by our simple formula? There are several reasons. Briefly reviewing them here will give us an idea of how far we have come since first introducing the multiplier.
One reason is that there are automatic stabilizers. Taxes in the United States are for the most part income-type taxes. Because incomes rise as the economy expands, tax revenues also increase. This increase in tax collections during expansions tends to dampen the rate of economic expansion.
The second reason that the size of the actual multiplier is small is that increases in government spending, without an increase in the money supply, tends to increase the interest rate. This, in turn, tends to crowd out some private investment spending, as well as household consumption spending. This rate increase diminishes the value of the government spending multiplier.
Third, when we developed the idea of the multiplier, we did so in the context of the Keynesian aggregate expenditure framework. In this framework, the price level is held constant in order to keep things simple. This assumption makes sense when the economy is on the flat part of the short-run aggregate supply curve, significantly below potential GDP. However, prices start to rise as the economy grows and begins to approach potential GDP. Because this increase in the price level has a negative effect on consumption spending, as well as for other reasons, the economy will not grow as much as predicted by the simple spending multiplier.
Fourth, the presence of excess capital and excess labor will dampen the rate of economic expansion. With excess capital, firms will not increase investment as much. With excess labor, firms will not hire as many new workers and household income will not increase as much. The dampening effects on investment and consumption will dampen the size of the multiplier.
Fifth, inventories tend to build up during economic downturns. When the economy begins to expand, firms will draw down some of their inventories. This dampens the increase in production from firms and helps to dampen the size of the multiplier.
Sixth, as explained by the life-cycle theory of consumption, people may perceive government policy as being temporary rather than permanent and may not respond greatly. For example, tax cuts that are temporary in nature will not bring about as big an increase in consumption spending as permanent tax cuts. As a result, the increase in GDP will be smaller.
Finally, the presence of the foreign sector of the economy reduces the size of the multiplier. If we did not buy any foreign goods, an increase in aggregate demand stemming from expansionary fiscal or monetary policy would mean all of the newly demanded goods and services would be domestically produced. However, because we buy many of our goods and services from other countries, this diminishes the increase in domestic aggregate output.
One of the main points to remember here is that if the government is considering a monetary or fiscal policy change, the response of the economy to the change is not likely to be large and quick. It takes time for the full effects to be felt, and in the final analysis, the effects are much smaller than the simple multiplier of earlier chapters led us to believe.