Fiscal Multiplier

The fiscal multiplier is an economic idea that comes from Keynes. The fiscal multiplier measures how strong the effect a stimulus will have on the economy.

In Keynesian theory, all consumers have some “marginal propensity to consume” (or MPC) which just means likelihood of spending dollars. Your MPC for buying chocolate might be higher than your sister’s, because you’re a chocoholic and she’s not. Yet, your sister’s overall MPC might be greater because she makes more money than you do.

The aggregate MPC (how much everyone together is spending at a given time) affects how large the fiscal multiplier is. If everyone’s feeling spend-happy, then $1 of stimulus money pumped into the economy by the U.S. federal government will have a relatively high fiscal multiplier. That $1 will be spent by someone, which then becomes someone else’s income to spend, which they spend, and so on and so on.

When everyone’s clutching their pearls and not feeling too spend-happy, then a $1 stimulus would have a small effect, since people’s marginal propensity to consume is relatively small. A smaller MPC will mean a stimulus will have a small effect, reducing the fiscal multiplier.