The Multiplier Effect
Assume the economy is in a recession. How much should aggregate
expenditures (AE) change in order to close a GDP gap and return to full
employment (YF)? Does a certain amount of spending result in an equal ,
greater or lesser amount of GDP (output and income)?
LRAS SRAS
Price
Level
PL1
The Multiplier Effect: a relatively small change in a component of
aggregate expenditures (C, I, G or Xn) leads to a LARGER change in
equilibrium GDP.
AD
Therefore: A GDP gap of $100 billion can be closed by a change in
C, I, G, or Xn of ______________ than $100 billion. Why and how?
Y1 YF
Key formula: ΔAE x Multiplier = Δ GDPe
Multiplier Formulas: M = 1/MPS or 1/1-MPC or ___________________
Real GDP
GDP Gap
(the difference between potential
output (YF) and actual output (Y1)
Key Assumptions: 1) the economy supports repetitive, continuous flows of
expenditures and income through which dollars spent by Smith are received as income by Chin, then spent by Chin and
received as income by Gonzales, and so on. 2) any change in income will cause both consumption and saving to vary in
the same direction as, and by, a fraction of, the change in income. (McConnell, pp. 183-184)
Multiplier explained: Assuming that all consumers spend .80 of any change in income (MPC) and correspondingly save
.20 of any change in income (MPS), $100 spent by Smith and received by Chin become income to Chin. If Chin spends
$80 and saves $20 of the income, the $80 spent and received by Gonzales becomes $80 in income to Gonzales. If
Gonzales spends $64 and saves $16, the $64 spent by Gonzales and received by Lopez become $64 in income to Lopez,
and so on. Please note, each expenditure gave rise to an amount of income, part of which was spent (MPC) and part of
which was saved (MPS). Therefore, an initial amount of expenditure ($100) gives rise to additional amounts of income
and spending ($80, $64, etc.). Note that even though the spending initiates an increase in spending and income as it
ripples through the economy, the leakage of savings means that there is an end point or maximum by which the income
and spending will be generated. It is IMPORTANT TO NOTE that the SPENDING MULTIPLIER described above is
NOT THE SAME as the DEPOSIT (MONEY) MULTIPLIER associated with money creation in the banking system.
Although the concepts are similar, they deal with completely different aspects of the economy (money creation vs.
generation of income and spending).
GDP = Yd
$370
$390
410
430
450
470
490
510
530
C
$375
390
405
420
435
450
465
480
495
S
-$5
0
5
10
15
20
25
30
35
APC
1.01
1.00
.99
.98
.97
.96
.95
.94
.93
APS
-.01
.00
.01
.02
.03
.04
.05
.06
.07
MPC
.75
.75
.75
.75
.75
.75
.75
.75
.75
MPS
.25
.25
.25
.25
.25
.25
.25
.25
.25
Based on the data above, complete the following:
↑ Yd ______ C ______ S
_______ APS _______ APC Please note that the MPC and MPS are relatively stable.
APC = Average Propensity to Consume = the fraction of income that is spent = ___________
APS = Average Propensity to Save = the fraction of income that is saved = _______________
MPC = Marginal Propensity to Consume = the fraction of any change in income that is spent: _______________
MPS = Marginal Propensity to Save = the fraction of any change in income that is saved: __________________
Because the MPS and MPC are fractions of any whole change in income: MPS + MPC = ______
Please note in the data used above, the MPC is derived by dividing the change in C (consistently 15) by the change in Yd (note the
change from one income to the next is 20); therefore, over all ranges of income, the MPC = 15/20 = .75. The MPS is derived by
dividing the change in S (consistently 5 in the data above) by the change in Yd (20); therefore, the MPS = 5/20 = .25. Knowing that
the MPC = .75, the MPS could be derived by the formula: 1-MPC. Or the MPC can be derived by the formula 1-MPS if the MPS is
known.
Important: Read p. 199 in your green textbook “Squaring the Economic Circle” by Art Buchwald ( or p. 216 in blue classroom text).
Multiplier Formulas: M = 1/MPS or 1/1-MPC or ΔGDPe/ΔAE
1.
2.
3.
4.
If the MPS = .20
the MPC = _____
the Multiplier = _____
If the MPC = .75
the MPS = _____
the Multiplier = _____
If the MPC = .90
the MPS = _____
the Multiplier = _____
If the change in GDPe = $20 billion and the change in AE = $5 billion, then the multiplier = _____ and
the MPC = _____ and the MPS = _____.
Use the multiplier to determine the amount of spending needed to close a GDP gap and return the economy to full
employment. Key formula: ΔAE x Multiplier = Δ GDPe
5.
If the GDP gap is $100 billion, how much must AE (C, I, G, or Xn) increase to return the economy to full
employment if the MPC = .80?
6.
If the GDP gap is $40 billion and the MPS = .25, what amount must AE increase to close the GDP gap?
7.
If the economy is in recession and has a GDP gap of $50 billion, how much must government increase G to close
the GDP gap and return to full employment, assuming an MPS of .20?
8.
If actual output exceeds potential output (YF) by $80 billion, how much must AE decrease in order to dissipate
the inflationary gap assuming the MPS = .25?
Does a change in G have the same effect as a change in T? No, a change in G can directly affect the economy. A
change in T results in a change in disposable income (Yd), but Yd can be either spent (C) or saved (S); therefore, a change
in T affects the economy only by a multiple of the amount that it changes C.
8.
Determine the effect on GDP of an increase in G of $20 billion if the MPC = .80 and the effect of a decrease in T
of $20 billion.
$20 x 5 = $100 billion
$20 billion in T → $20 billion in Yd. With an MPC of .80, C = $16 billion; therefore, the change in GDP =
$16 billion x 5 = $80 billion. Therefore, an increase in G of $20 billion has a greater impact ($100 billion) on the
economy than a decrease in taxes of $20 billion ($80). This is due to the leakage of savings in the case of taxes.
9.
What would be the effect on the economy (GDPe) of a decrease of $100 billion in G (or C, I or Xn) if the MPS
were .25?
What would be the impact on GDPe of an increase in taxes of $100 billion?
10.
Determine the effect on GDP of equal increases in both G and T of $50 billion given an MPC of .80? How
would this approach affect the government’s budget versus the effect on the economy?
Key idea: The balanced budget multiplier = 1. Therefore, 1 x the ΔG = the ΔGDPe if taxes and G are changed by the
same amount.
11.
12.
An increase in G and T of $50 billion would change GDPe how much? ______
A decrease in G and T of $30 billion would change GDPe how much? ______
Conclusion: A balanced budget has a(n) ____________________________ effect on the economy. (expansionary/contractionary?)