The Multiplier Effect: A Classroom Exercise

Abstract

Lowering taxes and raising government spending are both forms of expansionary fiscal policy. Often students mistakenly believe that their relative impact on GDP is equivalent, i.e. a dollar increase in government expenditure increases GDP by the same amount as a dollar decrease in taxes. This paper describes a classroom exercise that demonstrates a) how both fiscal stimuli create greater aggregate output and b) which fiscal stimulus spending is more effective. In this exercise, six students come to the front of class and act as business owners, the instructor acts as the government with a stimulus plan, and the remaining students are workers/consumers. Going through a sequence of financial decisions of how much to save and spend, students learn how the initial fiscal shock sets off a chain reaction, leading to successive rounds of changes in spending and income. This simple framework can then be used to evaluate the effect of relaxing standard assumptions, and to demonstrate the impact of automatic stabilizers such as taxes and transfer payments. Finally, this exercise can be used to facilitate a discussion on how the theoretical predictions differ from the actual real-world results due to credit liquidity restrictions, unemployment benefits, inflation, and governmental inefficiency.