Keynesian Multipliers Made Easy. Ok, maybe a little less hard is a better way to put it.

The Keynesian Multipliers, both the Govt/Investment and Tax Multipliers, can be a tricky concept.  I am going to TRY to simplify it as much as possible.

The Government/Investment multiplier is used when either Government and/or a Business increases or decreases expenditures.  It will tell us by how much GDP will increase/decrease given the eventual multiplier effect.

The Government or Investment Multiplier is determined by the simple equation:

1/MPS.

MPS is the "Marginal Propensity to Save" each additional dollar.

Example: If the MPS is 25% (.25) then the MPC (Marginal Propensity to Spend) is 75% (.75).

Remember: MPC + MPS = 100% (or +1)

1/25% = 1/.25 = +4.  

This means each additional dollar spent by either the Government or a Business will create, by the multiplier effect, +$4.00 in GDP in total (this includes the $1.00 originally spent too).

So, if Govt or a Business increases spending by +$100.00 then the eventual impact on GDP will be +$400.00 (+$100 X +4).  Easy, right?

The Tax Multiplier formula is a bit different and this is the one that usually confuses students.

The Tax Multiplier equation is:

  -MPC/MPS.   

Using the same Propensity numbers from our first example, we plug them into the equation:

-75%/25% = -.75/25 = -3.  

This is where it gets tricky---Notice the negative sign in front of the 3.  

If the Government wants to INCREASE GDP through tax policy, then it wants to CUT or DECREASE TAXES.  This will be a NEGATIVE amount from the Government's perspective.

If we multiply and Negative by a Negative we get a Positive, right?

So, if Government cut or decreased taxes by $100, then -$100 X -3 = +$300 INCREASE in GDP.

IMPORTANT POINT #1:    Notice we use the same Marginal Propensities in both cases, MPC or 75% and MPC of 25%.  We also use the same initial amount for "stimulus"---$100.

But we produced 2 different outcomes in terms of increasing GDP.

Government Spending that $100 produced $400 in GDP but the Tax Cut to individuals produced only an increase of $300 in GDP.

If you are a policy-maker and your charge is to get the economy going as quickly as possible and you had to choose only one of the above, which option is optimal, ceteris paribus?

IMPORTANT POINT #2:  Why is there a difference between the two multipliers?  Notice the Government Multiplier is "4" and the Tax Multiplier "-3".  Ignore the "-" sign in front of the 3, it is not important for this part.

The difference between the two numbers is "1".  The Government Multiplier is ALWAYS going to be one more than the Tax Multiplier (go ahead, using the formulas above change the MPS to 1%, 10%, 20%, 50% try it. You will get a difference of 1 EVERY TIME).

The difference is derived in the FIRST ROUND OF SPENDING. In the first round of spending it is assumed the Government DOES NOT save any of the $100.  The economy benefits by $100 immediately.

In the case of the Tax Cut it is assumed that the individual will SAVE a portion of that $100---25%.

So, in that first round of spending the economy benefits by only $75. Twenty-five dollar less!

All of the above is predicated on the $100 being borrowed, whether it is for the government spending or for the tax cut.  Either way, it will create a BUDGET DEFICIT.

The "Third Leg" of the Keynesian Multipliers is something called the "Balanced Budget Multiplier". This is how Keynes suggested a balanced budget could be maintained AND the economy can be stimulated. FUN STUFF!!

I will let you digest the lesson above and get busy writing the lesson for that to come soon.

I hope this helps.

I think the President SHOULD have said "The Federal employment sector is doing just fine". Here is the proof in one easy graph...

Planet Money at NPR has been following the change in government jobs at the Federal, State and Local level since the beginning of the recession. 

Due to the first large stimulus package in 2008 that aided states in budget crisis, employment actually increased for State and local governments during the downturn.

As you can see from the graph below since the exhaustion of Federal stimulus local government employment has taken the biggest hit, losing over 400,000 jobs, followed by State level jobs at loss of about 100,000.

Federal employment has remained elevated ABOVE pre-recession levels.

You could say "Federal employment is doing fine". State and local not so much.

How does this compare to private sector jobs?

Looking this next graph you can see the magnitude of government job loss, in relative terms, pales in comparison to private sector job loss.  We still have a long way to go....

Is re-paving a road "stimulative" to the economy? Compare these two photos. Are we using 1930's policies to solve 2011 problems?

Are "infrastructure projects" stimulating to the economy like they were during the Depression?  Are we using 1930's policies to solve 2011 problems? If the goal is to implement the use of machines/capital then we are doing the right thing. Road projects are a necessity, that is clear. But to justify them on the basis that they are, in large part, going to get our economy back on track and significantly lower unemployment seems a bit of a stretch to me.  If the goal of stimulus is to employ the masses, then, well, perhaps we should ask if "shovel-ready" is a literal or figurative term. More focus should be on the jobs of the future, not of the past...Just sayin'.

Repaving a road in Louisiana in the 1930's with a mix of labor and technology/capital...count the workers relative to capital...

Source HERE


Repaving a road today in Louisiana with today's mix of labor and technology...count the workers relative to capital

Source HERE

I assume the road in the bottom picture was done in a day or so and the road in the first picture took, well, I don't know how many days (weeks?)...

Fiscal Stimulus $2.00 at a time...Is reducing the Payroll Tax enough to "prime the pump"?

     One of the key components of the latest stimulus deal the President and the Republicans in Congress have hammered out is a decrease in the Social Security part of mandatory payroll taxes that just about everyone pays. The other part of the mandatory payroll tax is Medicare, but that is staying the same at 1.45%.   Currently 6.2% is taken out of paychecks and goes to the Social Security Trust fund to be distributed to "old" people in the form of a monthly check.  The compromise reduces this amount with-held by 2 percentage points, down to 4.2%.  For example: at 6.2% every $100.00 a worker earns he/she pays $6.20 in Social Securtiy taxes.  If the compromise becomes law, then only $4.20 will be with-held.  Soooo, a worker will retain $2.00 more for every $100.00 earned.  If a worker makes $500.00  a week, then their check will increase by $10.00.  The assumption is this money will be spent on goods and services and will stimulate the economy.
     There are two ways of looking at this. (1) The amount is so small for each person the stimulus will not be sufficient.  After all, what can you buy with $10.00 additional dollars per week that will make a significant difference? (2) Although the amount is small, there will be no debate about saving it or using it to pay debt. People will fully spend this extra money and the economy will get the maximum impact of the whole amount being spent, rather than just a portion. 
     I am not really sure what to think, so I ask you...is this "good or bad" stimulus?  Extra credit on the next test awaits!