David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

17 .2 Government and aggregate demand
than was necessary. When global financial meltdown began in 2008/09, governments thought they had
learned this lesson, and threw the kitchen sink at fixing the banks.
By early 2010, many of the banks seemed to have come back from the brink. The chart opposite shows the
share price of Royal Bank of Scotland, in which, during 2009, the government had to take an 84 per cent stake
in order to avert its collapse. Its share price having fallen from 400 pence to I 0 pence, it then seemed to
stabilize around 30-50 pence thereafter.
Improved private sector solvency has come at the price of reduced solvency for the government that
injected all the money. Whether the government can cope with its high debt burden is a subject to which
we return.
This leads to the third lesson from Japan. If pressing the fiscal accelerator is difficult once the government is
heavily indebted, the monetary accelerator must be flat on the floor. Japanese monetary policy eventually cut
interest rates to zero. Having learned from this experience, central banks in the US, the UK and eurozone
slashed interest rates to very low levels in 2009 when aggregate demand and output began to plummet.
The multiplier revisited
The multiplier relates changes in autonomous demand to changes in equilibrium income and output. The
formula in Chapter 16 still applies, provided we use MPC', the marginal propensity to consume out of
gross, rather than out of disposable, income.
Multiplier = 1/ (I -
MPC') (1)
With proportional taxes, MPC' equals MPC x (1 - t). For a given marginal propensity to consume out of
disposable income, a higher tax rate t reduces MPC', raises (I - MPC') and so reduces the multiplier. The
more the circular flow leaks out into taxation, the less flows round again to stimulate further expansion of
output and income. Table 17 .2 illustrates.
In Chapter 16, without government the multiplier was simply 1/(1 - MPC) or I/MPS. With a larger
marginal propensity to save, there was a larger leakage from the circular flow between firms and households,
and the multiplier was correspondingly smaller.
Table 17.2 merely extends this insight. Now leakages arise both from saving and from net taxes. When
both are large, the multiplier is small. The bottom row of the table has a much smaller multiplier than the
top row.
Table 17.2
Values of the multiplier
MPC
T
MPC'
Multiplier
0.9 0
0.9 0.2
0.7 0
0.7 0.2
0.7 0.4
0.90 10.00
0.72 3.57
0.70 3.33
0.56 2.27
0.42 1.72
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