Question

In 2007, Christina Romer, an economic policy adviser to President Obama, estimated the fiscal policy multiplier in the USA as approximately 1.6. Back in the 1930s, J. M. Keynes estimated the multiplier for the USA to be about 2.5.

If the Federal Government of the US had raised its spending by $20 bn, by how much would you expect GDP to have risen if Christina Romer’s estimate had been correct? How would you explain the difference in the estimates of the values of the multiplier of Keynes and Romer?

Answer 1

Fiscal policy multiplier is the total effect on GDP due to change in fiscal policy such as an increase or decrease in government spending or an increase or decrease in tax rates in the economy.

Fiscal Multiplier = 1 / ( 1 - MPC ) ( Marginal propensity to consume )

The main reason of existence of fiscal multiplier is the marginal propensity to consume. For example, an increase in government soending may increase aggregate demand, however how much demand will increase will depend on how much is the marginal propensity to consume.

Estimated fiscal policy multiplier in 2007 = 1.6

Therefore, an increase in spending by $20 billion would increase GDP by 20*1.6 = $32 billion. ( $12 billion dollar is net multiplier effect ).

Difference in fiscal multiplier is due to difference in marginal propensity to consume which was higher in 1930 than what it was in 2007.