Much ado about multipliers: A Reaction to "The Economist"

The title of Shakespeare’s 16^th Century play, Much ado about nothing, has taken on a meaning in modern language which defines a situation where a big deal is made out of something small. In the aptly named 2009 article from The Economist, Much ado about multipliers, the author argues that while adjusting taxes and government expenditures through the use of a fiscal multiplier does stimulate economic output, it is nearly impossible to predict what the output will be.

John Maynard Keynes, an influential 20^th century economist, relied heavily on fiscal multipliers in his work. He created the multiplier model, which explains how fluctuations of GDP inputs, namely: consumption, government expenditures, investment, and net exports, affect the economy as a whole. This model holds true the multiplier effect, which states that for every dollar spent, output changes by a multiple of that dollar.

The output gap in an economy is the difference between what the GDP could be and what it actually is. The government expenditure multiplier and tax multiplier work to close the output gap and bring an economy back to equilibrium. These two multipliers incorporate marginal propensity to consume and marginal propensity to save, which are measures of how much disposable income goes toward consumption and how much goes toward savings.  In the expenditure multiplier, expenditures are equal to 1 divided by 1 minus the MPC, which is always a decimal less than one. For example, if a government consumed 80% of their disposable income, their MPC would be .8, meaning the expenditure multiplier would equal 5 because 1 divided by .2 equals 5. This equation shows by how many dollars output will increase for each additional dollar the government spends. The government then applies this figure to another equation to decide how much to spend in order to close the output gap. This equation holds true that the expenditure multiplier is equal to change in GDP (ΔY) divided by change in government expenditure (ΔG). For example if a government needed to close an input gap of $4900 and their expenditure multiplier was 5, they would simply solve the equation for ΔG to find that they must increase expenditures by $980 to close the input gap completely. The tax multiplier works the same way, but replaces ΔG with ΔT, which represents change in taxes, and uses negative MPC because a decrease in taxes causes GDP growth. This equation shows by how much a government should reduce taxes in order to close the output gap.

 The In Much ado about multipliers, the author explains that although applying the multiplier is necessary to keep the economy running, the effectiveness of these changes are not as cut and dry as the equation makes them seem. There are many outside factors that contribute to how well a stimulus package will actually work. The author writes about how public perception causes variation in the effectiveness of stimulus packages. If consumers are given confidence by government action and invest more than before the stimulus package was put into effect, the GDP would increase much more than was originally intended; adversely, if interest rates increase due to stimulus, investment that would have originally occurred could be reduced, causing the multiplier to be less effective than planned. Like anything, there are always going to be unknown variables, which determine the way an original plan actually works. I believe that although the author says economists are “flying blind” when they try to predict how a multiplier will affect GDP; it is still vital to make these predictions to decide what is best for the economy. 

"Much Ado about Multipliers." Www.economist.com. The Economist, 24 Sept. 2009. Web. 17 Apr. 2013. <http://www.economist.com/node/14505361>.