Spending Multiplier

The federal government spends an additional dollar on a road project, and economists argue that total output rises by more than that dollar. What is the reasoning behind the claim?

1. A.Recipients spend part of the payment, which becomes income to others who spend part again.Correct. Each round of respending adds further income, so the initial outlay ripples outward through the economy.
2. B.The Federal Reserve must create additional money whenever federal spending increases.Wrong. The Fed's balance sheet is not tied to appropriations, and funding the outlay is a Treasury matter.
3. C.Government spending is counted twice in output, once as spending and once as income.Wrong. The national accounts are constructed precisely to avoid counting one transaction twice.
4. D.The completed road keeps producing measured output for years after the money is spent.Wrong. Long-lived assets may raise productivity later, but that is a separate argument from the demand multiplier.

Why: The multiplier rests on the fact that one person's spending is another person's income. Paying construction workers puts money in their hands, they spend part of it at local businesses, and those owners spend part of it in turn. Each round is smaller than the last because some of every payment is saved or spent on imports, so the total converges rather than growing without limit. The more of each additional dollar that households save, the smaller the multiplier, which is why identical spending has different effects in different conditions.

Legislators in the country of Bergland enact a $30 billion increase in government purchases. Economists advising the finance ministry estimate the marginal propensity to consume at 0.75 and instruct the committee to ignore taxes, imports and any offsetting central-bank action. Using the simple spending multiplier, the estimated increase in total output is closest to:

1. A.$22.5 billionThis multiplies $30 billion by 0.75, which is only the first round of induced consumption, not the full multiplier effect.
2. B.$30 billionThis assumes no multiplier at all. Induced consumption in later rounds is precisely what the multiplier captures.
3. C.$40 billionThis divides $30 billion by 0.75. The MPC belongs in the expression 1 - MPC, in the denominator of the multiplier.
4. D.$120 billionCorrect. The multiplier is 1 / (1 - 0.75) = 4, and 4 x $30 billion = $120 billion.

Why: The simple spending multiplier is 1 divided by (1 minus the marginal propensity to consume). With an MPC of 0.75 the multiplier is 1 / 0.25 = 4. Multiplying the $30 billion of new government purchases by 4 gives roughly $120 billion of additional output. The logic is that each round of spending becomes income to someone else, 75% of which is spent again.