Question

Consider the Keynesian model, which is based on examining the expenditure side of the economy (AE = C + I + G + X – M)!

Please, formulate 3 different macroeconomic policies in the context of this model that could potentially have a positive multiplier effect on the economy! Please, explain in 2-3 sentences, why would each of your proposed policies lead to a positive multiplier effect and what are the risks that could reduce the multiplier effect!

Answer 1

The three policies can be formulated as follows:

AE = C + I + G + X – M .............. (1)

1) Decrease in taxation: A decease in tax will increase the disposable income of the people and increase consumption in equation 1. Increased income and consumption leads to higher demand and increases the income for the producers. Since producers are themselves consuming, their increased income further creates additional income and the cycle creates multiplier effects. The multiplier effect depends on the marginal propensity to consume (MPC). If MPC is low, people won't consume the additional income and instead save. Saving will act as a leakage from the cycle an reduce the growth of income. The size of tax cut is also important as the multiplier will be lower, the lower the size of the cut.

2) Increase in government investment: The government undertakes expenditure on a lot of high importance projects which may not be extremely profitable for the private sector eg. public works like construction of roads, railway tracks, infrastructure etc. These projects have high returns in the long run and increase the income of people, which kicks in the multiplier effects. The multiplier will be lower if the projects fail or fail to generate any returns. There is also a risk of crowding out of private investments if the interest rates increase.

3) Incraese in government spending: The government is a major spender in the economy. Its spending creates income for the people and starts a virtuous multiplier. Unlike tax cut, there is no leakage in the form of savings as every dollar is spent by the government and therefore the multiplier value is typically higher. The risk is if the spending is seen as excess and beyond the means of the government. It can increase the fiscal deficits and uncertainty about fiscal position can lead to an increase in interest rates and declining private investor confidence.