Exploring Crowding Out

8. The Keynesian multiplier in the simplest textbook models is 1/(1-mpc). A quick look at data from the United States suggests that the mpc is quite high, at least .9. If people are given an extra dollar, on average they will spend at least 90 cents of it.

a. If we put .9 in the formula for the simple Keynesian multiplier, what do we get?

b. Suppose that government uses fiscal policy to increase spending. It spends another $1 billion dollars. In equilibrium, the model predicts that total income will increase by $ billion due to the increased government spending of $1 billion and induced consumption spending of $ billion.

c. Most economists think the multiplier is much smaller than that implied by the simple formula. One popular principles book by Hall and Liebenstein says that in the short run the multiplier is about 1.5, and in the long run it is zero.¹ This implies that in the short run the billion dollars of fiscal policy will increase total income by $ billion due to the increased government spending of $1 billion and induced consumption spending of $ billion.

d. Dividing induced spending in part b by induced spending in part c, we conclude that the simple model if off by a factor of about in predicting induced spending.

e. How seriously do you think we should take a model that makes predictions that are off by this factor?

^1.Macroeconomics: Principles and Applications by Robert E Hall and Marc Lieberman, Updated Second Edition (Thompson Southwestern, 2003), p 252: "Most forecasting models used by economists in business and government predict that the multiplier effect takes about nine months to a year to work its way through the economy. At the end of the process, the multiplier has a value of about 1.5. "

Web

ingrimayne.com

a. If we put .9 in the formula for the simple Keynesian multiplier, what do we get?
b. Suppose that government uses fiscal policy to increase spending. It spends another $1 billion dollars. In equilibrium, the model predicts that total income will increase by $ billion due to the increased government spending of $1 billion and induced consumption spending of $ billion.
c. Most economists think the multiplier is much smaller than that implied by the simple formula. One popular principles book by Hall and Liebenstein says that in the short run the multiplier is about 1.5, and in the long run it is zero.¹ This implies that in the short run the billion dollars of fiscal policy will increase total income by $ billion due to the increased government spending of $1 billion and induced consumption spending of $ billion.
d. Dividing induced spending in part b by induced spending in part c, we conclude that the simple model if off by a factor of about in predicting induced spending.
e. How seriously do you think we should take a model that makes predictions that are off by this factor?