KEYNESIAN_MULTIPLIER_EFFECTS 2.ppt

KEYNESIAN MULTIPLIER
EFFECTS
Let’s say you find a Rupee in the street.
You now have one Rupee you did not
have before. You now have an
“income” of one Rupee. What can you
do with that Rupee?? You can spend all
of it, save all of it, or spend some of it
and save some of it. You have options!

EFFECTS
 Let’s assume you decide to spend the
WHOLE Rupee. Your spending of that
Rupee is an EXPENDITURE for you and
INCOME for the person (entrepreneur) you
traded with.

EFFECTS
How much did GDP increase with this
transaction?
Rs.1.00
(you bought “stuff”)

EFFECTS
 Now what happens to that Rupee in the
possession of the entrepreneur? They
have the same options you had:
Spend it or Save it.

EFFECTS
Let’s assume the entrepreneur spends
the WHOLE Rupee at another
business.
This expenditure for the entrepreneur is
now INCOME for another
entrepreneur.

EFFECTS
How much did GDP increase with this
transaction?
Rs.1.00
Does this sound familiar??

EFFECTS
This “found” Rupee has now purchased
Rs.2.00 worth of goods and/or services.
The original Rupee appears to be cloning
itself!!

EFFECTS
If we repeat this pattern, it would go on
FOREVER and GDP would increase
INFINITLEY. Is this possible?
Unlikely…Why?

EFFECTS
People have a TENDENCY TO SAVE some
portion of each Rupee they receive.
Keynes had a fancy name for this: Marginal
Propensity to Save (MPS). In layman’s
terms this means people have a TENDENCY
TO SAVE A PORTION OF EACH
ADDITIONAL Rupee they receive.

EFFECTS
The flip side of this is people have a
TENDENCY TO SPEND (or CONSUME)
some portion of each Rupee they receive.
Keynes had a fancy name for this: Marginal
Propensity to Consume (MPC). In
layman’s terms this means people have a
TENDENCY TO CONSUME A PORTION OF
EACH ADDITIONAL Rupee they receive.

EFFECTS
 Example: If I get an additional Rupee I
may consume .90 and save .10.
 My Marginal Propensity to Consume
(MPC) that Rupee is then: 90%.
 My Marginal Propensity to Save (MPS)
that Rupee is then: 10%.

EFFECTS
 Example: If I get an additional Rupee I
may consume .80 and save .20.
 My Marginal Propensity to Consume
(MPC) is then: 80%.
 My Marginal Propensity to Save (MPS) is
then: 20%.

EFFECTS
Do you notice a pattern?
MPC + MPS = 1.00 (or 100%)

EFFECTS
 Let’s see how this works in practice.
 Assume the Government wants to increase
their spending by Rs.10 billion Rupees.
Assume that the MPC in the economy is 90%
and the MPS is 10% (remember these must
equal 100%). What is going to be the effect
on the GDP when we consider the Multiplier
effect of EACH of those Rupees?

EFFECTS
 The Government initially spends Rs.10
billion in the economy to purchase
goods and services. Does the
Government SAVE any of this money?
NO. They spend the whole shebang!
What is the immediate effect of this
transaction on GDP? It INCREASES by
Rs.10 billion.

EFFECTS
 What is now going to happen to that
Rs.10 billion now in the hands of people
in the economy? Keynes says that
people in general will spend 90% of it
and save 10%.
 So when people spend 90% of Rs.10
billion, how much is GDP going to
increase by? Rs.9 billion.

EFFECTS
 With these initial two transactions, how
much has GDP increase by?
Rs.10B + 9B = 19B
 Once again the original Rs.10B has
“magically” turned into Rs.19B in GDP
.

EFFECTS
 Now when people who receive the Rs.9B, they are
going to spend 90%, or Rs.8.1B and save 10%, or
Rs.900 Million.
 GDP is now growing again!
Rs.10B + Rs.9B + Rs.8.1B = Rs.27.1 Billion
It does not stop here. Each time the money is
spent it keeps reducing by the 90% and 10%
ratio UNTIL it gets to ZERO and GDP is some
much larger number.

EFFECTS
 Do you want to do all that math to
arrive at how much GDP is going to
increase in the end. I did not think so.
 Keynes came up with a simple formula
to do the math for you. Remember in
the beginning it was GOVERNMENT
that started this buying frenzy. This is
very IMPORTANT to remember.

EFFECTS
 The Keynesian Government Spending Multiplier is 1/MPS.
 Let’s use the information we have already been given: The MPC
is 90% and the MPS is 10%.
 We can plug the appropriate number into the Government
Spending Multiplier and come up with a useful number.
 Govt. Spending Multiplier =
1/MPS = 1/10% = 1/.10 = 10

EFFECTS
 Now this is AMAZING! According to KEYNES when
government spends a Rupee in the economy it is going to
purchase a multiple of 10 times itself in GDP.
 If Government increases spending by 10 Billion, then the
eventual impact on GDP is going to be an increase of:
Rs.10 Billion X 10 = Rs.100 Billion
NOTE: This works in REVERSE as well. If Government
DECREASES spending by Rs.10 Billion, it will serve to
DECREASE GDP by a multiple of 10!

EFFECTS
SUBTLETY ALERT!!
Notice in the VERY FIRST round of spending by the Government that
NOTHING is SAVED. The economy has the benefit of the FULL impact of
the Rs.10Billion in new spending. In subsequent rounds of spending people are
saving a portion of the money they receive, therefore REDUCING the impact on
the economy.
When we do the TAX CUT MULTIPLIER next, this distinction will be
important. It forms the foundation of why Keynes suggested that in times of
severe economic crisis it should be the role of Government to be “active” in the
economy.

EFFECTS
TAX CUT MULTIPLIER
 Instead of Government
changing its spending, they
could change TAXES instead.

EFFECTS
 Assume in the economy the MPC and the
MPS are still 90% and 10% respectively.
 Assume the Government decides to REDUCE
taxes by Rs.10 Billion. This means that
Rs.10B is now in the hands of people and
NOT in the hands of the Government.
According to Keynes, what is the first thing
that people in the economy are going to do
with that new Rs.10Billion?? They are going
to Spend 90% and Save 10%!!

EFFECTS
 When they spend 90% it is going to
INCREASE GDP by Rs.9Billion in the
FIRST ROUND of Spending (how does
that compare when in the previous
example Government spent FIRST).
 This transaction INCREASED GDP by
Rs.9B.

EFFECTS
 The people who receive the Rs.9B are
going to SPEND 90%, or Rs.8.1Billion
and SAVE Rs.900 Million.
 This transaction will INCREASE GDP
by Rs.8.1Billion.
GDP is now Rs.9B + Rs.8.1B =
Rs.17.1Billion.

EFFECTS
 The people who receive the Rs.8.1Billion are going to
SPEND 90%, or Rs.7.290 Billion and SAVE 10%, or Rs.810
Million
 This transaction will INCREASE GDP by Rs.7.290 Billion.
GDP is now Rs.9B + Rs.8.1B + 7.29B = 24.390Billion.
 Once again, it does not stop here. Each time the money is
spent it keeps reducing by the 90% and 10% ratio UNTIL
it gets to ZERO and GDP is some much larger
number.

EFFECTS
 Keynes came up with a simple formula to do
the math for you. Remember in the
beginning it was PEOPLE in the Economy
that start this buying frenzy. This is very
IMPORTANT to remember.
The KEYNESIAN TAX CUT MULTIPLIER = -MPC/MPS.
 WOW that will be hard to remember!

EFFECTS
 Example:
 We know the MPC is 90% and the MPS is 10%.
 We can plug the appropriate number into the Tax Cut
Multiplier and come up with a useful number.
 Tax Cut Multiplier
-MPC/MPS = 90%/10% = .-,90/.10 = -9

EFFECTS
 According to Keynes if the Government REDUCED
TAXES (-) and you multiply by the TAX CUT
MULTIPLIER, that is how much GDP will
INCREASE.
 In our example, the Government DECREASED taxes
by 10Billion (-) and you multiply this by the tax cut
multiplier of -9, then GDP will eventually INCREASE
(two negatives make a positive) by Rs.90Billion.
 NOTE: This works in REVERSE. If Government INCREASE TAXES by
Rs.10Billion then this will serve to DECREASE GDP by a multiple of –9.
(+10billion X -9 = -90Billion).

EFFECTS
NOT SO “SUBTLE” ALERT!!!
Do you notice the different effects of the Government
Spending Multiplier and the Tax Cut Multiplier? The
Government Spending Multiplier appears to ALWAYS
come out ahead of the Tax Cut Multiplier in terms of how
much GDP is eventually impacted.
THIS IS THE POINT Of THESE KEYNESIAN
MULTIPLIERS!!
According to Keynes, INCREASED Government spending
“outperforms” DECREASES in Taxes to stimulate (“prime
the pump”) the economy.

EFFECTS
 Let’s put these Keynesian Multipliers together
and see how it all washes out
 Assume the Government wants to do the
right thing when they INCREASE
Government spending they ALSO INCREASE
Taxes to pay for it, so they won’t have to
borrow to pay for the spending. Novel idea, I
know, but it could happen…NOT!

EFFECTS
 Assume Government want to
INCREASE spending by Rs.20 Billion
and the MPC is 80% and the MPS is
20%. If they don’t want to create a
budget deficit they must INCREASE
Taxes by Rs.20 Billion to pay for the
new spending.
 What is going to be the NET EFFECT
of this action on the Economy?

EFFECTS
 Calculate the Government Spending
Multiplier (1/MPS = 1/20% = 1/.20 =
5)
 If government spending INCREASES
by Rs.20B and the multiplier is 5 then,
GDP is going to INCREASE by
Rs.100B (Rs.20B X 5 = Rs.100B).

EFFECTS
 This is only half the story…Now we have to take
Rs.20B OUT of the Economy in TAXES to pay for the
new spending.
 Calculate the TAX CUT MULTIPLIER
(-MPC/MPS = -80%/20%=-.80/.20 = -4)
 If TAXES are INCREASED by Rs.20B and the tax cut
multiplier is -4 then GDP is going to DECREASE by
Rs.80B ( +20B X -4 = -80B)
 The multiplier effect is working in REVERSE to
DECREASE GDP by a multiple of 4!

EFFECTS
 What is the NET EFFECT after the TWO MULTIPLIERS do
their work?
 The INCREASED Government Spending has
INCREASED the GDP by Rs.100B
 The Tax INCREASE has DECREASED the GDP by -80B.
 BOTTON LINE: GDP (AGGREGATE DEMAND) has
INCREASED by Rs.20B!! The Miracle of the Keynesian
Multiplier…
 NOTE: This works in REVERSE as well. If Government Spending DECREASED by
Rs.20B and DECREASED Taxes by Rs.20B, then the NET EFFECT on the Economy
will be a Net DECREASE in GDP of -Rs.20B. THE HORRORS!!

EFFECTS
Think about this: Government
INCRESED spending by Rs.20B and
INCREASED Taxes by Rs.20B to pay
for the spending and the economy
came out AHEAD by Rs.20B in
INCREASED GDP. Notice a
pattern??

EFFECTS
NOT SO SUBTLE ALERT:
Pick any Rupee amount that Government
could increase it spending by and increase
taxes by the SAME amount to maintain a
BALANCED BUDGET. The result will be an
INCREASE in GDP by the SAME amount
that you increased spending and
increased taxes. Cool, huh!!

EFFECTS
 Keynes called this the BALANCED BUDGET
MULTIPLIER
The BALANCED BUDGET MULTIPLIER is 1
 Take whatever you INCREASE Government
Spending and INCREASE Taxes by and
Multiply by 1 you will get what the NET
INCREASE is in GDP.
Note: THIS WORKS IN REVERSE AS WELL

EFFECTS
 Let’s Do Some Examples…
 Assume we can determine there is a
recessionary gap in the Economy of Rs.100
Billion.
 Assume the MPC is 75% and the MPS is 25%
 If the Govt. decides to change spending,
would they INCREASE or DECREASE
spending? By How Much?

EFFECTS
 Determine the Govt. Multiplier.
1/MPS = 1/25% = 1/.25 = 4
This means that ANY Rupee the Govt spends in the economy is
going to multiply on itself 4 TIMES
The Recessionary Gap is Rs.100B
Rs.100/4 = Rs.25 Billion
This is the amount Govt. would INCREASE spending to close
this Rs.100B gap (move closer to Full-Employment)

EFFECTS
 Assume we can determine there is a
recessionary gap in the Economy of
Rs.100 Billion.
 Assume the MPC is 75% and the MPS is
25%
 If the Govt. decides to change TAXES
would they INCREASE or DECREASE
Taxes? By How Much?

EFFECTS
 Determine the TAX CUT MULTIPLIER.
-MPC/MPS = -75%/25% = -.75/.25 = -3
This means that ANY Rupee received in Tax Cuts in the economy is
going to multiply on itself 3 TIMES
The Recessionary Gap is Rs.100B
Rs.100/-3 = -Rs.33.33 Billion
(-Rs.33B X -3 = Rs.100B)
This is the amount Govt. would DECREASE TAXES by to close
thisRs.100B gap (move closer to Full-Employment)

KEYNESIAN_MULTIPLIER_EFFECTS 2.ppt

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