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The Multiplier Effect Review for AP Economics

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By — McGraw-Hill Professional
Updated on Apr 25, 2014

Review questions for this study guide can be found at:

Consumption, Saving, Investment, and the Multiplier Review Questions for AP Economics

Main Topics: The Multiplier Effect and Spending Multiplier, Public and Foreign Sectors, The Tax Multiplier, Balanced Budget Multiplier

The most simple circular flow consists solely of consumers and firms; in other words, GDP = C+ I.But the public sector (G) and foreign sector (XM) are also important sources of domestic spending and income. Inclusion of these two sectors provides very little in the way of complications; they introduce the concept of the spending multiplier, the tax multiplier, and the balanced budget multiplier. This also paves the way for fiscal policy aimed at macroeconomic stability.

The Multiplier Effect and Spending Multiplier

When you buy an ear of corn at the farmer's market, those dollars serve as income to several people. The farmers use those dollars to pay employees, to run their farm equipment, and to buy their own food. Farm employees use those wages to buy bacon, pay the rent, and many other goods and services. The circular flow explains how the injection of a few dollars of spending creates many more dollars of spending. Follow the dollars for a few rounds to see how it works. With the marginal propensity to consume of .80, if households receive a $1 of new income they spend $.80 and save $.20.

Round 1:Firms increaseinvestment spending by $10,which acts as an injection of new money into the economy.

Round 2:The $10acts as income to resource suppliers (households) and with an MPC = .80, households spend $8and save $2.

Round 3:The $8of new consumption spending (C) is income for other households and they also spend 80 percent, or $6.40and save $1.60.

Round 4:The $6.40of new Cis income for other households and they spend 80 percent, or $5.12, and save $1.28.

This process repeats. Each time the dollars circulate through the economy, 80 percent is spent, and 20 percent is saved. After only four rounds, there has been $10 + 8 + 6.40 + 5.12 = $29.52 of new GDP. The process continues until households are trying to consume 80 percent of virtually nothing and the increase in new GDP comes to an eventual stop.

This is called the multiplier effect. A change in any component of autonomous spending creates a larger change in GDP. The discussion of the "rounds" of spending above implies that the marginal propensities to consume and save play a critical role in determining the magnitude of the multiplier. There are two equivalent ways to calculate the multiplier if you know the MPC or MPS. The magnitude of the spending multiplieris found by taking a ratio:

Multiplier = 1/(1 – MPC) = 1/ (1 – .80) = 5.
Since MPC + MPS = 1,
Multiplier = 1/MPS = 1/.20 = 5.

The spending multiplier can be found by using one of the following equations:

Some common autonomous multipliers are:

The Public and Foreign Sectors

The inclusion of government spending (G) and net exports (XM) act in the very same way as the change in investment illustrated in the above example.

Government Spending (G)

With the MPC = .80, we have found the spending multiplier equal to 5. If autonomous government spending is incorporated into the circular flow model, the multiplier effect is again felt throughout the economy. If G= $20, we could expect those $20 to multiply to $100 in new GDP.

Net Exports (X –M)

The final sector of the macroeconomy is the foreign sector. The addition or subtraction (if imports exceed exports) of autonomous net exports is an increase (or decrease) of dollars in the circular flow. Using a spending multiplier of 5, if (XM) = $10, GDP would increase by $50.

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