Balanced Budget Multiplier

Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Balanced Budget Multiplier?

A balanced budget multiplier quantifies changes in total output. This metric considers an equal change in government spending and taxation. An economic multiplier denotes the impact of change in one economic variable over other.

Balanced Budget Multiplier

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The term typically refers to government budgets. In governmental budgeting, cost levels are strictly regulated because revenues are more or less fixed. A balanced budget has a multiplier of one—the change in production neutralizes the change in taxation (except the initial amount of production).

Key Takeaways

  • The balanced budget multiplier measures the change in aggregate production caused by government taxation and spending changes.
  • The multiplier evaluates fiscal policy changes affecting taxes and government expenditures.
  • In a balanced budget, total anticipated revenues and total anticipated expenditures are equal.
  • When revenues exceed expenses, we call it a budget surplus. In contrast, when expenses exceed collected revenue, we call it a deficit. Thus, a balanced budget operates at a surplus during economic growth and uses reserves during economic crises.

Explained

The balanced budget multiplier is taken as ‘one’. This implies the increase in production triggered by reduced taxation is neutralized. This metric combines the tax multiplier and expenditure multiplier.

The tax multiplier gauges the impact of tax changes on aggregate production. Similarly, the expenditure multiplier gauges the impact of aggregate expenditure on production. Thus, a balanced budget equalizes spending and taxation. The balanced multiplier examines what happens when taxes and government spending changes are equal. The budget multiplier measures the impact of taxes and spending (in equal measure) by tracking changes in total output.

The government maintains the same budget deficit or surplus—taxation changes offset spending. For instance, if government spending rises from $600 to $800, that is a $200 increase. The government also increases taxes concurrently by $200, from R$ 700 to R$ 900. Thus, the budget surplus remains unchanged at $100.

When revenues exceed expenses, we call it a budget surplus. In contrast, the expense is called a fiscal deficit when it exceeds collected revenue. When economic activities decline, a budget deficit can help the economy—in the form of extra spending.

In contrast, the best time to implement a budget surplus is during rapid economic growth. Therefore, the government should clear its debt during growth and save for future recessions and financial crises.

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Formula of Balanced Budget Multiplier

The balanced budget multiplier formula is as follows:

In a closed economy, the following condition characterizes short-term equilibrium:

Y = C + I + G

  • Here, Y is output (income).
  • C is consumption.
  • I denote investment.
  • G denotes government spending.

The balanced multiplier is calculated by multiplying the simple expenditures multiplier by the simple tax multiplier:

Further, to calculate MPC, we use the following formula:

The marginal propensity to consume (MPC) is the increase in consumer spending owing to the increase in disposable income. Disposable income is the portion of the gross annual income left with individuals after paying off all their financial liabilities, including federal and state taxes. Disposable income is the real income people can spend fulfilling their household needs, investments, and savings.

Suppose the marginal propensity to consume is greater than one. In that case, it indicates that the change in income level has resulted in a relatively larger change in the consumption of the particular good. Such a correlation is a characteristic of goods with the price elasticity of demand greater than one (luxury items).

On the other hand, the marginal propensity to save is the extra disposable income that goes into savings.

Example

Let us look at an example.

A government raises autonomous tax by $100, resulting in a $100 reduction in private-sector disposable income. Even though MPC is less than one, a $100 decrease in disposable income does not necessarily result in a $100 decrease in consumer goods and services. MPC is 0.8, and an increase in tax results in an $80 decrease in expenditure. The remaining $20 has been saved.

Let us apply the given values to the formula:

  • Consumption = MPC x Disposable Revenue
  • Consumption = 0.8 x 100 = 80

Diagram

Let us look at the balanced budget multiplier diagram.

The Keynesian multiplier was developed using the concept of change in aggregate demand. It states that the economic output is a multiple of the increase or decrease in spending. If the fiscal multiplier is greater than one, a $1 increase in spending will increase total output by more than $1.

Balanced Budget Multiplier Diagram

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The above diagram shows that a small increase in governmental expenditure resulted in a larger increase in national income — C1 to C2 (from consumption function 1 to consumption function 2).

Further, this triggers an increase in output from Y1 to Y2. This occurs because national income is a reflection of total expenditure in an economy.

  • Here, C stands for Consumption
  • S stands for Savings.

Importance

Let us discuss the importance of a balanced budget multiplier.

  • A balanced budget can be critical for a government entity for two reasons. First, it may need help to sell sufficient debt securities to cover deficits. Second, taxpayers will be burdened with higher taxes to cover the deficit in the future.
  • By balancing the budget, the government saves on interest by avoiding large loans from the International Monetary Fund (IMF) and the World Bank.
  • The balancing concept advocates the maintenance of a budget surplus during economic growth. Thus, such governments wield better control during financial crises.
  • During crises. A budget deficit can be beneficial—excess spending can boost economic activity.

Frequently Asked Questions (FAQs)

What are the various characteristics of a balanced budget multiplier?

The tax and expenditure multiplier is aggregated to formulate the budget multiplier. It tracks changes in total output. Here, the change in taxes and spending is kept equal.

What is the policy implication of a balanced budget multiplier?

The balanced budget multiplier has policy implications in that, in theory, changes in government spending and taxation do not affect the overall level of economic activity. A government cannot stimulate the economy by raising or lowering taxes. As a result, the balanced budget multiplier suggests that governments should be cautious when using fiscal policy to influence the economy.

Why is the balanced budget multiplier equal to 1

The balanced budget multiplier is one because it assumes that any increase in government spending is matched by an equal increase in taxation, resulting in a balanced budget. This means that the increase in aggregate demand brought about by increased government spending is offset by the decrease in aggregate demand brought about by increased taxation.

This has been a guide to what is Balanced Budget Multiplier. Here, we explain its formula, example, importance, and diagram. You can learn more about it from the following articles –

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