Keynesian Multiplier (HL)

You are expected to explain/analyze (AO2) and calculate (AO4) the Keynesian multiplier effect (HL)

<-- Back to Macro

<- Back to 3.6

Goals and Tools

Expansionary and Contractionary

Keynesian Multiplier (HL)

Effectiveness of Fiscal Policy

This page is for Higher Level students only.

Understanding (AO2)

The Keynesian multiplier is a theory showing that an initial injection of money into the economy results in a proportionately larger increase in Aggregate Demand.

This happens because of the circular flow of income; When money is spent, it goes to someone else who also spends it, and so on.

Let's say the government wants to build a new highway for $1B. This money goes to the construction contractors, who then spends it on wages and equipment. Those workers spend that money on various goods and services in the economy. All of this adds up to more than $1B.

Calculating the Keynesian multiplier (AO4)

MPC: Marginal Propensity to Consume: If you give a person $1, how much of that will they spend
MPS: Marginal Propensity to Save: If you give a person $1, how much of that will they save (doesn't count towards GDP)
MPT: Marginal Propensity to Tax: If you give a person $1, how much of that will be taxed (doesn't count towards GDP)
MPM: Marginal Propensity to Import: If you give a person $1, how much of that will they spend on imported products (doesn't count towards GDP)

The 4 variables add up to 1.

Calculate changes in AD using the multiplier (AO4)

Using the multiplier, you can find the change in GDP as a result of a government fiscal policy.

Looking back at our $1B highway project as an example, let's say it is found that the marginal propensity to consume in the economy is 0.6 (for every $1 earned by people, they spend $0.6 of that).

Keynesian multiplier = 1 / (1-0.6) = 2.5

Now multiply the initial investment ($1B) by 2.5, and you get $2.5B. This is the total increase in real GDP from this government expenditure.

The Keynesian multiplier usually increases the effect investments have on real GDP. It therefore acts as a way to support/justify expensive government intervention, which is an important part of Keynesian philosophy.