The Multiplier EffectThis is a featured page

-The multiplier effect shows that an initial change in spending can cause a larger change in DI and output.
- The multiplier determines how much larger that change will be; it is the ratio of a change in GDP to the initial change in spending.
- It measures the effect that any change in expenditure (I, G,C, or Xn) will have on GDP

Multiplier = 1/(1-MPC) = 1/MPS

- When person A spends their money, it becomes person B's income. Then person B will go spend their income which then becomes person C's money, etc. The cycle repeats, but because of the tendency to save which stays the same for every person percentage wise, the amount spent in each cycle is less and less.

Multiplier = change in real GDP/ initial change in spending
(*Change in GDP = mutlplier*initial change in spending)

The Investment Multiplier is always one more than Tax Multiplier

  • Based on two facts:
    • The economy supports repetitive, continuous flows of expenditures and income
    • Any change in income will vary both consumption and saving in the same direction as, and by a fraction of, the change in income
  • Initial change in spending will set off a spending chain throughout the economy
    • Chain of spending, although of diminishing importance at each successive step, will cumulate to a multiple change in GDP
    • Eg. If the government chooses to spend an extra $10 million on hotels, the factors of production regarding the buliding industry will increase by $10 million; however, some (the MPC * 10 million) of this increase in income will be spent on local consumer goods needed for the hotel. Thus, more than just $10 million worth of goods and services are produced, hence why the multiplier effect is needed.

The multiplier and marginal propensities:
  • The higher the MPC (thus, lower MPS), the larger the multiplier because the multiplier is equal to the reciprocal of the marginal propensity to save
  • The multiplier is equal to the reciprocal of the marginal propensity to save: the greater is the marginal propensity to save, the smaller is the multiplier. also, the greater is the marginal propensity to consume, the larger is the multiplier.
  • The idea that every dollar of spending creates more than one dollar in economic activity.
  • Multiplier formulas
    • Investment multiplier = 1/ (1-MPC) OR 1/ MPS
    • Government multiplier = 1/ (1-MPC) OR 1/MPS
    • Tax multiplier = - MPC/ (1-MPC) OR - MPC/ MPS

The Multiplier Effect - Welker's Wikinomics Page

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