CAPE Economics

Unit 2, Module 1
The Balanced Budget Multiplier

The Balanced Budget Multiplier (BBM)

If government revenues and expenditure increase or decrease
simultaneously and equally, i.e. if G increases/decreases by amount X,
and T also increases/decreases by amount X
Then National Income (Y) will also change in the same amount.
This means that the BBM = 1.
How it Works
Assume that we operate in an economy with an MPC of 0.75.
So the multiplier in this scenario is 1/(1-0.75) = 4
Government increases both spending and taxes by $1b.
The increase in government spending causes an increase in aggregate
expenditure of $1b. Government is doing the spending so it is, in a
sense, autonomous. The MPC doesnt come into play (yet).
The increase in taxes causes a decrease in aggregate expenditure of
$0.75b. Why is this the case? The increase in taxes means a reduction
of $1b in aggregate income in the economy. However, we know that the
MPC = 0.75, i.e. that any change of X in aggregate income will cause a
change of 0.75X in aggregate expenditure. In this case, therefore, the
fall in aggregate expenditure is 0.75 x $1b = $0.75b.
The net increase in aggregate spending by government, therefore, is
$1b - $0.75b = $0.25b.
The multiplier effect kicks in at this point, giving a final increase in
National Income of:
4 x $0.25b = $1b.
Coincidence? Not Really.
Its no coincidence that the BBM = 1, i.e. that an increase of G/T by
some amount triggers an equivalent increase in Y.
In our example, only the initial $1 billion government purchase triggers
an increase in aggregate output.
Each subsequent round of increased consumption that would be
otherwise induced by the multiplier process is offset by decreased
consumption resulting by higher taxes. The only expenditure that does
not go through the household sector and is not cancelled by taxes is the
original government purchase.