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Balanced budget multiplier


The multiplier effect on national income of an increase in government expenditure exactly matched by an increase in taxation, so that the balance of the government's budget remains unchanged. It might be thought that an increase in government expenditure of, say, £100m, if matched by an increase in taxation of fl00m., would have no net effect on aggregate demand in the economy and that national income would remain unchanged. This is not in general the case, however: there will usually be an expansionary effect. At its simplest, the reason for this is that only part of the increase in taxation results in lower aggregate demand, while all the increased expenditure results in increased aggregate demand so that there is a net injection of demand into the economy, which then has a multiplier effect. Thus suppose income earners save 20 per cent of their disposable income and spend the rest. An increase in taxation of £100m reduces disposable income by the same amount, reduces saving by £20m and consumer expenditure by £80m. Aggregate dei;nand falls by only f80m, therefore. The £100m extra expenditure adds directly to aggregate demand, so there is a net addi­tion to aggregate demand of £20m, which will then have a multiplier effect. This is the balanced budget multiplier.

Reference: The Penguin Business Dictionary, 3rd edt.