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.