Lesson 4 of 5 · 14 min

The fiscal multiplier, balanced budgets and Ricardian equivalence

Each unit of new government spending is re-spent in shrinking rounds, so output rises by a multiple 1/[1 − c(1 − t)] of it; a tax-financed rise in spending still lifts output by one-for-one, and if Ricardian equivalence holds a debt-financed tax cut changes nothing.

In short

  • MPC (c): share of an extra unit of disposable income that is spent; MPS (s) = 1 − c.
  • With a net tax rate t, disposable income is YD=(1−t)YY_D = (1 - t)Y and the effective propensity to spend out of national income is c(1−t)c(1 - t).
  • Fiscal multiplier = 1/[1−c(1−t)]1/[1 - c(1 - t)]. Higher MPC raises it; higher tax rates shrink it.
  • Balanced budget multiplier = 1: raising G and taxes by the same amount still raises output, because part of the tax would have been saved anyway.
  • Ricardian equivalence: if people foresee the future taxes needed to repay new debt, they save a debt-financed tax cut and spending is unchanged.
  • Multiplier effects need spare capacity; near full employment, extra demand mainly raises prices.

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The fiscal multiplier, balanced budgets and Ricardian equivalence · Fiscal Policy