Nov 24 2008

The Multiplier Effect as it applies to the Obama camp’s fiscal stimulus proposal

Below is the explanation of the “Multiplier effect” from our class wiki, as explained by my Econ students:

• The multiplier effect shows that an initial change in spending can cause a larger change in national income and output.
• The multiplier determines how much larger that change will be; it is the ratio of a change in GDP to the initial change in spending.
• It measures the effect that any change in expenditure (Investment, Government spending, Consumption, or Net exports) will have on GDP

Multiplier = 1/(1-MPC) = 1/MPS
Multiplier = change in real GDP/ initial change in spending
Change in GDP = mutlplier x the initial change in spending

Rationale: The multiplier is explained based on the following facts:

• The economy supports repetitive, continuous flows of expenditures and income
• Any change in income will vary both consumption and saving in the same direction as, and by a fraction of, the change in income
• Initial change in spending will set off a spending chain throughout the economy
• Chain of spending, although of diminishing importance at each successive step, will accumulate and result in a multiple change in GDP

Harvard Economist Gregory Mankiw has applied the concept of the spending multiplier to the proposal coming from Barack Obama’s economic transition team to inject as much as \$700 billion of goverment spending into the economy to stimulate aggregate demand and help America escape its recession. Mankiw quotes today’s Washington Post:

Facing an increasingly ominous economic outlook, President-elect Barack Obama and other Democrats are rapidly ratcheting up plans for a massive fiscal stimulus program that could total as much as \$700 billion over the next two years….Obama has set a goal of creating or preserving 2.5 million jobs by 2011.

Mankiw, the Econ teacher that he is, applies the basic formula for the Spending Multiplier to the numbers coming from the Obama camp, and finds the following:

Dividing one number by the other, that (the \$700b of government spending) works out to \$280,000 per job.

What is going on here? Logically, it must be one of three possibilities:

1. The fiscal stimulus is going to be much smaller than is being reported.
2. The new administration is setting a low bar for itself when it comes to job creation.
3. The Obama team believes in very small fiscal policy multipliers.

Let me amplify the last point. The average weekly earnings of production and nonsupervisory workers is about \$600, or about \$60,000 over a two-year period. Granted, labor income is only about two-thirds of national income, and we have to add a few supervisors into the mix.

So let’s say each job created means \$100,000 of extra national income. If we are generating \$100,000 of income with \$280,000 of government spending, the multiplier is only 100/280, or 0.36. Traditional Keynesian models suggest a multiplier closer to 2.0.

What Mankiw has found, using simple economic analysis understood by anyone who has studied AP or IB Economics, is that if we believe in the numbers given by the Obama camp itself, then government spending package of \$700 billion will result in roughly \$250 billion of new income for the nation.

How did we find this? Simply by applying the forumula given on our wiki above: Multiplier = change in real GDP/ initial change in spending, and plugging in the numbers calculated by Mankiw:

• Multiplier = 0.36.
• Change in spending = \$700b.
• Therefore, the change in national income (or GDP) equals \$700b x 0.36 = \$252 billion

Perhaps Mr. Obama needs to consider the basic economic principle of the Spending Multiplier before he goes around throwing out numbers about the jobs that will be created or preserved from a new fiscal stimulus package. Clearly, 2.5 million jobs grossing an average of \$100,000 each over two years, while SOUNDING good, in reality represents a truly unbelievable squandering of wealth and income by the US government.

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

4 Responses to “The Multiplier Effect as it applies to the Obama camp’s fiscal stimulus proposal”

1. Lorretta Wondraon 30 Nov 1999 at 1:00 am

Thank you, I’ve recently been searching for information approximately this topic for ages and yours is the best I have came upon till now. However, what concerning the bottom line? Are you certain concerning the supply?

2. Genki U.on 24 Nov 2008 at 11:16 pm

I was reading this article this morning, but Mankiw's numbers are entirely speculative and aren't actual projections by the Obama Administration, as far as I know. Greg is placing an educated guess (I assume) on returns per head given that 700 billion dollars is some how used for exclusively saving jobs and not actually suggesting that 100K will be created per 280K put in the money hole.

3. […] The Multiplier Effect as it applies to the Obama camp’s fiscal stimulus proposal […]

4. Alanon 22 Jun 2012 at 6:38 pm

Mankiw's numbers are wrong from the get go. For example, replacing a bridge requires purchasing the materials as well as the actual labor to build it. Then there are the machines used. Guess what, people were hired to make the materials and build / maintain the machines. Local services were used by the crew. These jobs may be part time promoted to full time or jobs saved from layoff. It would appear that Mankiw is only using the actual construction crew.

• Order Welker’s books

for IB Economics

for AP Macro