Lesson 4 of 6 · All lessons in this module
- Monetary versus fiscal policy and the roles of fiscal policy
- Deficits, national debt and whether debt matters
- Fiscal policy tools and what makes a good tax
- The fiscal multiplier, balanced budgets and Ricardian equivalenceVideo lesson
- Fiscal stance and the difficulties of implementation
- Integrated cases: costing a fiscal package
Lesson 4 of 6 · 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 and the effective propensity to spend out of national income is .
- Fiscal multiplier = . 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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