Multiplier Effect Flashcards

Multiplier Effect

• The multiplier effect refers to additional shifts in aggregate demand.
• For example, when expansionary fiscal policy increases income:
  • This income increase leads to additional increases in consumer spending.
  • Which cause incomes to increase again.
  • And consumer spending to increase again, and so on.

Multiplier Effect Example

• Consider an increase in government purchases by $20$ billion.
• Aggregate-demand curve shifts to the right by exactly $20$ billion initially.
• Consumers respond by increasing spending, causing the aggregate-demand curve to shift right again.

Figure 4: The Multiplier Effect

• An increase in government purchases of $20$ billion can shift the aggregate-demand curve to the right by more than $20$ billion.
• This multiplier effect arises because increases in aggregate income stimulate additional spending by consumers.
  • An increase in government purchases of $20$ billion initially increases aggregate demand by $20$ billion.
  • The multiplier effect can amplify the shift in aggregate demand.

Multiplier Effect: Size of Effect

• The size of the multiplier effect depends on the Marginal Propensity to Consume (MPC).
• MPC is the fraction of extra income that consumers spend.
• The remaining portion of the extra income is saved.
• For example, if the MPC is $0.80$, then for every new dollar, 80 cents is consumed, and 20 cents is saved.

Multiplier Effect: Example with MPC

• Suppose government spending is increased by $20$ billion, and the MPC is $0.50$.
  • 1: AD increases by $20$ billion.
  • 2: AD increases by $20$ billion x $0.5 = 10$ billion.
  • 3: AD increases by $10$ billion x $0.5 = 5$ billion.
  • 4: AD increases by $5$ billion x $0.5 = 2.5$ billion.
  • 5: AD increases by $2.5$ billion x $0.5 = 1.25$ billion, and so on.
• Total Effect = $20 + 10 + 5 + 2.5 + 1.25 + … = 40$ billion.

Multiplier Formula

• Multiplier = $1 / (1 – MPC)$
• In our example, $20$ billion in government purchases results in:
  • $20$ billion x $(1 / (1 - 0.5)) = 20$ billion x $(2) = 40$ billion increase in AD.
• What if MPC is larger? Suppose MPC = $0.80$?
  • $20$ billion x $(1 / (1 – 0.8)) = 20$ billion x $(5) = 100$ billion increase in AD.
• Notice that the larger the MPC, the larger the multiplier effect.