Question

1. Elementary macroeconomic models (such as our Model II, Models and Multipliers) suggest that the multiplier effect associated with an increase in government spending can be estimated according to the formula m = 1 / 1-MPC. Therefore, if the country’s MPC is 0.8, then a $500 billion in government spending should lead to an increase in aggregate income of some $2.5 trillion. And if the MPC is more like 0.9, then the multiplier effect suggests the increase in income would be in the $5 trillion range. However, government “stimulus” packages never produce results of such magnitudes. This question has two parts, but both deal with the overall question of WHY?? a) Unlike the simplifying assumptions of Model II, the real world economy does have foreign trade, taxes are not levied and collected lump-sum style, etc., etc., etc., that is, the actual economy is more akin to one represented by something more in line with the Model VII case. Considering/estimating the parameter values for such a model, what is a more realistic value for a government expenditures multiplier? (Note: I want numbers, not formulas) b) Aside for damping effects explained by examining the models (as suggested in (a) above, what other factors would account for the much less-than-promised impact of government stimulus packages?

Answer 1

a. A more realistic value of government expenditure multiplier is less than 5. It is close to 3-3.5 because apart from marginal propoensity to consume, marginal propensity to import also has an impact on the level of government expenditure multiplier. Spending on imports reduces the value of government spending multiplier because it represents a leakage in the economy because expenditure is made on foreign goods and not on the domestic goods. Thus, the value of government spending multiplier is less than 5.

b. Other factors that can lead to much less than promised impact of government stimulus packages includes increase in the level of interest rate due to increase in government expenditure and thus leads to crowding out of private investment in the economy. This reduces the overall impact on the level of national income in the economy and thus reducing the stimulatory impact of increase in government expenditure.