The Multiplier Effect of Government Spending

Based on these arguments, let us investigate the multiplier effect of government spending again. In case (i), temporary expansion does not affect permanent income even if 0 > 0. We do not have the permanent income effect. Thus, because of the direct substitution effect, private consumption declines by the amount of 0. Namely, in Fig. 3.8a, the direct effect from E0 to E2 is nowl— 0, and the multiplier becomes less thanl— 0.

In case (ii), since current government spending does not change, we do not have the direct substitution effect between government spending and private consumption. However, we have the permanent income effect. Permanent government spending produces an increase in effective permanent income by the amount of 0.

Thus, in Fig. 3.8b, the movement from E0 to E2 produces an expansionary effect by the size of — 1 + 0. Since an increase in permanent government spending raises the tax burden by 1 and the benefits of government spending by 0, effective permanent income does not decline more than —1. The multiplier becomes more than —1+ 0 and less than 0.

Case (iii) is the sum of case (i) and case (ii). Since the direct income effect and the permanent income effect offset each other, the multiplier remains 0, irrespective of the size of 0.

Evaluation of Government Spending

In reality, how much is 0? If 0 is greater than 1, in cases (i) and (ii) the sign of the multiplier changes to its opposite. In this regard, the benefit of government spending is significantly large. When the initial level of government spending is small, the marginal benefit of spending is large. The marginal benefit decreases with the size of government spending. The multiplier effect deals with the marginal impact of government spending. Thus, 0 should reflect the marginal evaluation of government spending. Since government spending increases greatly in a welfare state, the value of 0 is not as large and is likely to be less than 1.

The Advanced Study of this chapter investigates more fully the effect of 0 on consumption.

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