Expansionary fiscal policy can impact the gross domestic product (GDP) through the fiscal multiplier. The fiscal multiplier (which is not to be confused with the monetary multiplier) is the ratio of a change in national income to the change in government spending that causes it. When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect.
The multiplier effect arises when an initial incremental amount of government spending leads to increased income and consumption, increasing income further, and hence further increasing consumption, and so on, resulting in an overall increase in national income that is greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change. The multiplier effect has been used as an argument for the efficacy of government spending or taxation relief to stimulate aggregate demand.
For example, suppose the government spends $1 million to build a plant . The money does not disappear, but rather becomes wages to builders, revenue to suppliers, etc. The builders then will have more disposable income, and consumption may rise, so that aggregate demand will also rise. Suppose further that recipients of the new spending by the builder in turn spend their new income, raising demand and possibly consumption further, and so on. The increase in the gross domestic product is the sum of the increases in net income of everyone affected. If the builder receives $1 million and pays out $800,000 to sub contractors, he has a net income of $200,000 and a corresponding increase in disposable income (the amount remaining after taxes). This process proceeds down the line through subcontractors and their employees, each experiencing an increase in disposable income to the degree the new work they perform does not displace other work they are already performing. Each participant who experiences an increase in disposable income then spends some portion of it on final (consumer) goods, according to his or her marginal propensity to consume, which causes the cycle to repeat an arbitrary number of times, limited only by the spare capacity available.
Fiscal Multiplier Example
The money spent on construction of a plant becomes wages to builders. The builders will have more disposable income, increasing their consumption and the aggregate demand.
In certain cases multiplier values of less than one have been empirically measured, suggesting that certain types of government spending crowd out private investment or consumer spending that would have otherwise taken place.