Sizing a Fiscal Policy Action

A recessionary gap means real GDP sits below potential GDP. The government could try to close it with spending or tax changes, but any dollar injected into the economy doesn't just vanish after one transaction. A construction worker who gets a government contract spends part of that pay at a grocery store; the grocery store owner spends part of that on rent; the landlord spends part of that on dinner. Each round adds to GDP, so the initial dollar's total effect is multiplied. That multiplier is 1/(1-MPC), where MPC is the marginal propensity to consume, the share of each extra dollar a household spends rather than saves.

Because spending gets multiplied, the government only needs to inject enough spending so that, after all the rounds of re-spending, the total increase in GDP equals the gap. That required injection is the gap divided by the multiplier, which is the same as the gap times (1-MPC). A tax cut works differently: households save part of any tax cut instead of spending all of it, so the first round is already smaller. The tax multiplier is MPC/(1-MPC), smaller than the spending multiplier 1/(1-MPC), so a larger tax cut than spending increase is needed to close the same gap.

This topic is where the abstract multiplier idea from earlier becomes the actual sizing tool for fiscal policy. It connects directly to shifting aggregate demand to close recessionary or inflationary gaps, and it sets up why policymakers must know MPC fairly precisely to avoid overshooting or undershooting potential GDP.