Fiscal policy can have a multiplier effect on the economy. For example, if a $100 increase in government spending causes the GDP to increase by $150, then the spending multiplier is 1.5. In addition to the spending multiplier, other types of fiscal multipliers can also be calculated, like multipliers that describe the effects of changing taxes. The size of the multiplier effect depends upon the fiscal policy.
Expansionary fiscal policy can lead to an increase in real GDP that is larger than the initial rise in aggregate spending caused by the policy. Conversely, contractionary fiscal policy can lead to a fall in real GDP that is larger than the initial reduction in aggregate spending caused by the policy .
Multiplier Effect
The multiplier effect determines the extent to which fiscal policy shifts the aggregate demand curve and impacts output.
The size of the shift of the aggregate demand curve and the change in output depend on the type of fiscal policy. The multiplier on changes in government purchases, 1/(1 - MPC), is larger than the multiplier on changes in taxes, MPC/(1 - MPC), because part of any change in taxes or transfers is absorbed by savings. In both of these equations, recall that MPC is the marginal propensity to consume.
For example, the government hands out $50 billion in the form of tax cuts. There is no direct effect on aggregate demand by government purchases of goods and services. Instead, GDP goes up only because households spend some of that $50 billion. But how much will they spend? Households will spend MPC*$50 billion (where MPC is the marginal propensity to consume). If MPC is equal to 0.6, the first-round increase in consumer spending will be $30 billion (0.6*$50 billion = $30 billion). The initial rise in consumer spending will lead to a series of subsequent rounds in which the real GDP, disposable income, and consumer spending rise further.