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What Exactly Is The Multiplier Model?

The multiplier model is a macroeconomic theory that explains how output is determined in the short-run. It shows how one dollar of change in investment, exports, government spending, or taxes can lead to a change in GDP that is greater than one dollar due to multiplier effects. The size of the multiplier depends on the marginal propensity to consume (MPC), with a higher MPC resulting in a larger multiplier. Fiscal policy tools like government spending and taxation can be used according to their multiplier sizes to achieve macroeconomic goals.

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87 views32 pages

What Exactly Is The Multiplier Model?

The multiplier model is a macroeconomic theory that explains how output is determined in the short-run. It shows how one dollar of change in investment, exports, government spending, or taxes can lead to a change in GDP that is greater than one dollar due to multiplier effects. The size of the multiplier depends on the marginal propensity to consume (MPC), with a higher MPC resulting in a larger multiplier. Fiscal policy tools like government spending and taxation can be used according to their multiplier sizes to achieve macroeconomic goals.

Uploaded by

annsaralonde
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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What exactly is the Multiplier

Model?
It is a Macroeconomic theory used to explain how
output is determined in the short-run.

The name multiplier comes from the finding that


each dollar change in exogenous expenditure
leads to more than a dollar change in GDP.

It explains how shocks to investment, foreign


trade and government tax & spending policies can
affect output and employment in an
economy.
Key Assumptions:
Wages and prices are fixed
There are unemployed resources
We suppress the role of monetary
policy
We assume that there are no
financial market reactions to changes
in economy
First Approach:
OUTPUT DETERMINATION WITH
SAVING AND
INVESTMENT

How investment and saving


are equilibrated in the
multiplier model?
Recall:
Consumption Function Savings
Function
Consumption Function

Each point on the


consumption function
shows desired or
planned
consumption at that
level of disposable
income.
Saving Function

Each point on the saving


schedule shows desired
or planned saving at
that income.

The two schedules are


close related since C+S =
DI.

They are mirror twins


that will always add up to
the 45 line.
Savings and Investment

Depends on different factors:

Savings Investment
Disposable Income Output
Interest rates
Tax policies
Business Confidence

Investment as an exogenous variable


determined outside the model.
At this level of
Assume the investment output, desired S
will be exactly the same of HH equals
per year regardless of the desired I of Firms
level of GDP.

This will mean it is a


horizontal line.

The saving &


investment schedules
intersects at pt. E. This
corresponds to a level of
GDP given at pt. M &
represents equilibrium At equilibrium: No inventories piling up
level of output in the on their shelves, nor will their sales be so
multiplier model. brisk as to force them to produce more
goods.

Production, employment, income,


Disequilibrium

GDP is higher than E


At point A, GDP is to the right
of M at an income level where
the saving schedule is higher
than the investment
schedule.

HH: Saving > F:


Investment

What will happen?


Firms will have too few
customers and larger
inventories of unsold goods.

What to do?
Cut production lay off
workers GDP
equilibrium.
Second Approach:
OUTPUT DETERMINED BY
TOTAL EXPENDITURES
Total desired Expenditure (TE)
TOTAL desired expenditure of
TE = Consumption
EXPENDITURE consumers & businessmen at
Function + desired each level of output
investment (C+I)

At any point on the 45


line, total desired
expenditure is equal to
total desired output.

The economy is
equilibrium if TE
crosses the 45 line, in
this case point E.

At point E, the level of


desired expenditure on
consumption and Consumption Function
investment is equal to the desired consumption at each
level of income
Where is the MULTIPLIER in
this?
To answer the question
We need to examine how a change
in exogenous investment
spending affects GDP.

We all know that an increase in


investment will increase level of
output and employment.

But by how much?


Multiplier
Impact of a 1-dollar change in exogenous
expenditures on total output.

In the simple C+I model, the multiplier is the


ratio of the change in total output to the
change in investment.

Example:
An increase in investment by P100B, can cause an
increase in output of P300B, thus the multiplier is
3.
Suppose we hire carpenters to build a waiting shed
that
costs $ 1000.
(1) This carpenters will earn an extra income of
$1000.
(2) If they have MPC of 2/3, they will now
spend $666.67 on new consumption goods.
(3) The producer of this goods, will now have an
income of $666.67.
(4) If their MPC is also 2/3, they will spend
$444.44 or 2/3 of $666.67.
(5) The process will go on with each round of
spending being 2/3.
This will result to an endless chain of secondary
consumption spending which is set in motion by the
primary investment of $1000. Eventually it adds up to a
finite amount.
Using arithmetic:
$1000 1 x $1000
++
$666.67 2/3 x $1000
++
$444.44 (2/3) x $1000
+ = +
$296.30 (2/3) x $1000
++
197.53 (2/3)x $1000
++
____
$3,000 1 x $1000, or 3 x $1000
1- 2/3
This shows that, with an MPC of 2/3, the multiplier
is 3; it consist of the 1 of primary investment plus
2 extra of secondary consumption spending.

The size of the multiplier thus depends upon how


large is the MPC.

It can also be expressed in terms of the twin concept,


the MPS. If MPS is , the MPC is , and the
multiplier is 4.

Multiplier Formula: 1 x change in


investment
1 - MPC
Can we get the same result using the graphical
analysis of saving and investment?

Change in New
Investment equilibrium

Yes. Suppose the


change in investment
is $100B, MPS is 1/3,
therefore, multiplier
is 3. What will be the
new equilibrium
GDP? The answer is
$3,900B.
Increase in income is exactly
3 times the increase in
investment.
FISCAL POLICY IN THE
MULTIPLIER MODEL
Fiscal Policy
Instrument in deciding how the
nations output should be divided
between collective and private
consumption and how the burden
of payment for collective goods
should be divided among the
population.

This has impacts on the short-run


movements of output, employment &
HOW GOVERNMENT FISCAL POLICIES
AFFECTS OUTPUT?
New Total Expenditure
To understand the role of government in economic
activity, we need to look at government
purchases and taxation, along with the effects
of those activities on private sector spending.

We now modify our earlier analysis by adding G to


C+I.

TE = C+I+G New Total Expenditure: this can now


describe the new equilibrium when government,
with its spending and taxing, is in the picture.
Consumption Changes when TAXES are present
The consumption function
changes when taxes are
present.

Decrease
In the original CF, GDP = in
DI; Income
3,000=3,000.
Original
With introduction of taxes CF
amounting to 300, at DI of
3,000, GDP = 3,300 Tax

CF with
200 is the result of Tax
multiplying a decrease in
income of 300 times MPC
0f 2/3.
Effects of including government purchases
This figure is just like the
previous diagrams. Here we
added a new expenditure New
stream, G, to the consumption equilibrium
& investment. when G is
added
We place this on top of C+I.
Why?
1. It has same macroecon
impact as spending on
private buildings.
2. Collective expenditure
involve in buying
government vehicle.
3. Has same effect on jobs as
private consumption
expenditures on
automobiles.
Impact of Taxation on Aggregate Demand

Extra taxes lower DI reduce


consumption spending.

If investment and government


purchases remain the same, a
reduction in consumption spending
will then reduce GDP & employment.

Thus, in the multiplier, higher taxes


without increase in government
FISCAL-POLICY
MULTIPLIERS
The multiplier analysis shows that
government fiscal policy is high
powered spending much like
investment.

It should have a multiplier effects


upon output.
Government Expenditure Multiplier

An increase in GDP resulting from


an increase of $1 in government
purchases of goods & services.

An initial government purchase of a


good or service will set in motion a
chain of spending.

If government builds a road, the


road-builders will spend some of their
The ultimate effect of on GDP of an extra dollar of G
will be the same as the effect of an extra dollar
of I.
The multipliers I equal to 1
An increase of $100B in G 1-MPC
will have an ultimate
increase in GDP equal to
$100B primary spending
times the expenditure
multiplier.

In this case, because MPC


= 2/3, the equilibrium
level of GDP is $300B.

This example tells us that


Govt expenditure
multiplier is the same as
the investment
multiplier.

They are both


Tax Multiplier
Taxes also have an impact upon the
equilibrium GDP, although it is tax
multiplier is smaller than
expenditure multipliers.

Thus, offsetting an increase in


government purchases requires an
increase in tax larger than the
increase in G.
Multipliers in Action
A realistic understanding of the size of multipliers
is a crucial part of diagnosis and prescriptions in
economic policy. (like physicians must know the
effect of different dosages of their medicines).

They have to know the magnitude of expenditure and


tax multipliers.

When economy is growing too rapidly and a dose of


fiscal austerity is prescribed, the economic doctor
needs to know the actual size of multipliers
before deciding how large a dose of tax
increases or expenditure reductions to order.
Beyond the Multiplier Model
Macroeconomics understanding requires
understanding not just the models but also
their strengths and weaknesses.
Among the simplifications of the simplest
multiplier model are the following:
The MM ignores the impact of money and
credit upon consumption & investment.
The simplest MM ignores the way foreign trade
affects output at home & abroad.
Aggregate supply is left out of the story, so
we have no way of analyzing how increases in
spending are divided between prices and output.

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