How a Stimulus Package Raises National Income

Question

The Singapore government announced the Covid-19 Resilience Package amidst the pandemic. This stimulus package includes multiple transfer payments from the government to consumers and businesses to help them tide through difficult times during Covid-19.

(a) Explain how these stimulus packages could work to increase national income. [10]

Answer

A stimulus package of transfer payments to households and firms is a form of expansionary fiscal policy. It raises national income in two linked stages: first by lifting the components of aggregate demand, and then by amplifying that initial injection through the multiplier.

Stage 1 — the stimulus raises C, I and G. Transfer payments are themselves a form of government expenditure ( $G$ ). By raising household disposable income, they lift consumption expenditure ( $C$ ); by raising firms’ post-tax cash flow, they support investment expenditure ( $I$ ). As the mechanism of fiscal policy runs, the rise in $G$ , $C$ and $I$ together raises aggregate demand, shifting the AD curve to the right.

Stage 2 — the multiplier amplifies the injection. The initial injection does not raise national income only by its own value. Suppose the package injects $10 million into the economy. The firms and households who first receive it see their income rise by $10 million, and re-spend a fraction of it on domestically produced goods determined by the marginal propensity to consume (MPC). With an MPC of 0.5, $5 million is re-spent, becoming income for a further set of households, who in turn spend $2.5 million, and so on. Each round is half the size of the last, and the increments shrink to nothing. The multiplier effect means the eventual rise in national income is a multiple of the original injection — here, with a multiplier of $\frac{1}{1-0.5} = 2$ , a $10 million injection raises national income by $20 million.

This compounding of spending and re-spending is what shifts aggregate demand outward by more than the initial injection.

Stimulus package raises national income: the initial injection shifts AD₀ to AD', and induced re-spending through the multiplier carries the curve further to AD₁ in the intermediate range — real national output rises from Y₀ to Y₁ and the general price level rises from P₀ to P₁.

In sum, the stimulus package raises national income by injecting spending directly through $G$ and indirectly through $C$ and $I$ , and that injection is magnified by the multiplier so that the final rise in real national output exceeds the initial sum the government disbursed.