The Size of the Multiplier

We can finally bring together the material in this chapter and in previous chapt
ers to consider the
size of the multiplier.We mentioned in Chapter 23 that much of the analysis we w
ould do after
deriving the simple multiplier would have the effect of decreasing the size of t
he multiplier.We
can now summarize why.
1. There are automatic stabilizers.We saw in the Appendix to Chapter 24 that if
taxes are not a
fixed amount but instead depend on income (which is surely the case in practice)
, the size
of the multiplier is decreased. When the economy expands and income increases, t
he
amount of taxes collected increases. The rise in taxes acts to offset some of th
e expansion
(thus, a smaller multiplier). When the economy contracts and income decreases, t
he
amount of taxes collected decreases. This decrease in taxes helps to lessen the
contraction.
Some transfer payments also respond to the state of the economy and act as autom
atic stabilizers,
lowering the value of the multiplier. Unemployment benefits are the best example
of transfer payments that increase during contractions and decrease during expan
sions.
2. There is the interest rate.We saw in Chapter 27 that if government spending i
ncreases and the
money supply remains unchanged, the interest rate increases, which decreases pla
nned investment
and aggregate output (income). This crowding out of planned investment decreases
the
value of the multiplier. As we saw earlier in this chapter, increases in the int
erest rate also have
a negative effect on consumption. Consumption is also crowded out in the same wa
y that
planned investment is, and this effect lowers the value of the multiplier even f
urther.
3. There is the response of the price level.We also saw in Chapter 27 that some
of the effect of
an expansionary policy is to increase the price level. The multiplier is smaller
because of this
price response. The multiplier is particularly small when the economy is on the
steep part of
the AS curve, where most of the effect of an expansionary policy is to increase
prices.
4. There are excess capital and excess labor. When firms are holding excess labo
r and capital,
part of any output increase can come from putting the excess labor and capital b
ack to work
instead of increasing employment and investment. This lowers the value of the mu
ltiplier
because (1) investment increases less than it would have if there were no excess
capital and
(2) consumption increases less than it would have if employment (and thus househ
old
income) had increased more.
5. There are inventories. Part of any initial increase in sales can come from dr
awing down
inventories instead of increasing output. To the extent that firms draw down the
ir inventories

in the short run, the value of the multiplier is lower because output does not r
espond as
quickly to demand changes.
6. There are people s expectations about the future. People look ahead, and they r
espond less to
temporary changes than to permanent changes. The multiplier effects for policy c
hanges perceived
to be temporary are smaller than those for policy changes perceived to be perman
ent.
The Size of the Multiplier in Practice In practice, the multiplier probably has
a value
of around 2.0. Its size also depends on how long ago the spending increase began
. For example, in
the first quarter of an increase in government spending, the multiplier is only
about 1.1. If government
spending rises by $1 billion, GDP will increase by about $1.1 billion during the
first
quarter. In the second quarter, the multiplier will rise to about 1.6. The multi
plier then will rise to
its peak of about 2.0 in the fourth quarter.
One of the main points to remember here is that if the government is contemplati
ng a monetary
or fiscal policy change, the response of the economy to the change is not likely
to be large
and quick. It takes time for the full effects to be felt, and in the final analy
sis, the effects are much
smaller than the simple multiplier we discussed in Chapter 23 would lead one to
believe.
A good way to review much of the material since Chapter 23 is to make sure you c
learly
understand how the value of the multiplier is affected by each of the additions
to the simple
model in Chapter 23.