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CoreEconomics, 2e

Interactive Examples
The Multiplier Effect and Crowding Out
Economists estimate the effect of additional spending, whether it is through consumption, investment, or government purchases, by calculating the size of the spending multiplier.
Question 1:
What is the formula for the spending multiplier?
Answer

Interactive Examples
The Multiplier Effect and Crowding Out
Economists estimate the effect of additional spending on equilibrium income, whether the additional spending comes from consumption, investment, or government purchases, by calculating size of the spending multiplier.
Question 1:
What is the formula for the spending multiplier?
Next
Answer to Question 1: k = 1/(1-MPC) k is the spending multiplier and MPC is the marginal propensity to consume.

Interactive Examples
The Multiplier Effect and Crowding Out
Question 2:
If the marginal propensity to consume is 90%, what is the spending multiplier?
Answer

Interactive Examples
The Multiplier Effect and Crowding Out
Question 2:
If the marginal propensity to consume is 90%, what is the spending multiplier?
Next
Answer to Question 2:
Using the formula k = 1/(1-MPC), we find that the spending multiplier is 10.
k = 1/(1-.90) k = 1/.10
k = 10

Interactive Examples
The Multiplier Effect and Crowding Out
Question 3:
If the marginal propensity to save is 20%, what is the spending multiplier?
Answer

Interactive Examples
The Multiplier Effect and Crowding Out
Question 3:
If the marginal propensity to save is 20%, what is the spending multiplier?
Next
Answer to Question 3:
Recall that the marginal propensity to save (MPS) is equal to 1-MPC. Thus, applying the spending multiplier formula, we find the spending multiplier is 5.
k = 1/(1-MPC) k = 1/MPS k = 1/.20
k = 5

Interactive Examples
The Multiplier Effect and Crowding Out
Question 4:
Assume the current equilibrium income in the economy is $5,000,000. If the full employment equilibrium income is $6,600,000, and the spending multiplier is 4, what amount of government spending would bring us to the full employment equilibrium?
Answer

Interactive Examples
The Multiplier Effect and Crowding Out
Question 4:
Assume the current equilibrium income in the economy is $5,000,000. If the full employment equilibrium income is $6,600,000, and the spending multiplier is 4, what amount of government spending would bring us to the full employment equilibrium?
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Answer to Question 4:
A spending multiplier of 4 implies that income will rise $4 for every $1 in spending.
Since the economy needs an additional $1,600,000 in income to reach the full employment equilibrium, $400,000 in spending would be required.

The Multiplier Effect and Crowding Out
Question 5:
Explain what causes the spending multiplier to be greater than one.
Interactive Examples
Answer

Interactive Examples
The Multiplier Effect and Crowding Out
Question 5:
Explain what causes the spending multiplier to be greater than one.
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Answer to Question 5:
A spending multiplier greater than one occurs when increased government spending stimulates more private spending by consumers and businesses in the economy. For example, when the government spends money on building or repairing roads and bridges, the workers who are hired for the job may increase their spending (thus increasing consumption) and the construction company performing the work may buy new equipment for the job (thus increasing investment).
The total increase in spending (and GDP) is therefore more than the initial increase in government spending.

The Multiplier Effect and Crowding Out
Question 6:
What causes the crowding out effect?
Interactive Examples
Answer

Interactive Examples
The Multiplier Effect and Crowding Out
Question 6:
What causes the crowding out effect?
Answer to Question 6:
There are several possible sources of crowding out. First, higher government spending may be financed by higher taxes which reduce private consumption spending. Second, higher government spending may be financed by borrowing (issuing government bonds) which reduces spending on private bonds, therefore decreasing private investment spending. Third, if government borrowing to finance increases in government spending reaches high enough levels, the issue of additional bonds may depress bond prices and raise interest rates. Higher interest rates make consumer and business spending more expensive, thus further decreasing private consumption and investment.
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