MP

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.