Fiscal Stimulus: Definition, Multiplier Effect & Price Levels

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Fiscal stimulus is additional government spending or tax cuts designed to increase aggregate demand when the economy is not performing up to its potential. We will work through an example to show how fiscal stimulus works and how much is needed.

What is Fiscal Stimulus?

The Chairman pounded the gavel and cleared his throat, ''This meeting of the Council of Economic Advisers is now in session!'' he thundered. ''Today our task is a difficult one, we have to come up with some ideas for the President and Congress about how we can get this economy moving again.''

Adam, one of the Chairman's assistants, then got up and did a quick review for the rest of the group on what the Chairman was talking about. ''Fiscal stimulus refers to changes in government policies regarding spending and taxes designed to increase aggregate demand.''

Aggregate Demand

What is aggregate demand? Aggregate demand (AD) is the total demand for goods and services from the whole economy. It comes from three sources:

  1. Consumer spending - This is the total that the citizens spend for goods and services.
  2. Business investment - This is what business spends on building productive capacity. Examples are a new factory or an office building.
  3. Government spending - This is what government spends on purchasing goods and services. Examples are new roads or airplanes for the military. It also includes government transfers to citizens, like social security and veterans' benefits. Fiscal stimulus has the goal of increasing aggregate demand.

Recessionary Gap

This economy has a recessionary gap because its equilibrium results in a GDP below its potential.

Adam went on to talk about the recessionary gap facing the economy caused by an aggregate demand shortfall. ''You see we have an equilibrium where aggregate demand crosses aggregate supply. And when that comes up short of potential GDP the economy is suffering from weak performance and unemployment. That means politicians will lose their jobs!'' he said. That caused a stir in the room. ''You can see from the graph that when AD increases the curve will move up and to the right. That will make the new equilibrium at a higher GDP level but also raise the price level. So, we will need to increase AD by $25 million to get the new equilibrium to the potential GDP level of $50 million. It is important to remember not to do too much since stimulus will increase AD and the GDP, but also drive up prices.''

The Multiplier Effect

The Chairman then summarized for the group. ''Our job is pretty simple then, we have a $25 million dollar shortfall in aggregate demand as seen on Adam's table, so we just advise Congress to increase government purchases by $25 million and it's done with, right?''

'''No sir'' replied Tammy, one of the advisers. ''It's not that simple because of the multiplier effect. You see, money just doesn't get spent and fall down a black hole, it circulates around the economy. Whoever gets the money will save some of it and spend the rest. For example, when a contractor gets paid $1 million dollars for a road project, he will spend some of it at his suppliers to buy asphalt and gravel, and pay some more of it to his crew. Then the supplier and his workers will spend that money yet again at the grocery store to feed their families. So you see,'' Tammy concluded, ''that million dollars we spend on purchases will generate a whole lot more economic activity than just a million!''

The Chairman wondered just how much more than a million. ''Can we measure that?'' he asked.

''Sure.'' replied Tammy, ''Just use the multiplier formula.''

Multiplier Formula

  • Multiplier = 1 / (1 - MPC)

MPC is the marginal propensity to consume. The MPC is how much of a dollar of additional income is spent rather than saved. In our economy, 20% will be saved and 80% will be spent or consumed. The MPC is 80% or 0.80.

The multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5.

So, every new dollar spent on purchases by the government will raise AD by $5.

Increasing Government Purchases

''So, if Congress wants to raise aggregate demand by $25 million,'' the Chairman said, ''They won't have to spend that much because of the multiplier, right?''

'''Now you get this sir,'' Tammy replied, ''and I have another formula that will tell us just what Congress needs to spend on purchases to increase aggregate demand by $25 million. It's called the desired fiscal stimulus formula.'' she said.

  • Desired fiscal stimulus = Aggregate demand shortfall / Multiplier

Using the formula, if the aggregate demand shortfall is $25 million and the multiplier is 5, then the desired fiscal stimulus is $25 / 5 = $5 Million.

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