Page 727 - The Principle of Economics

CHAPTER 32 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND 747
Multiplier􏰁1􏰂MPC􏰂MPC2 􏰂MPC3 􏰂····
This multiplier tells us the demand for goods and services that each dollar of gov- ernment purchases generates.
To simplify this equation for the multiplier, recall from math class that this ex- pression is an infinite geometric series. For x between 􏰃1 and 􏰂1,
1􏰂x􏰂x2 􏰂x3 􏰂 In our case, x 􏰁 MPC. Thus,
···
􏰁1/(1􏰃x).
Multiplier 􏰁 1/(1 􏰃 MPC).
For example, if MPC is 3/4, the multiplier is 1/(1 􏰃 3/4), which is 4. In this case, the $20 billion of government spending generates $80 billion of demand for goods and services.
This formula for the multiplier shows an important conclusion: The size of the multiplier depends on the marginal propensity to consume. Whereas an MPC of 3/4 leads to a multiplier of 4, an MPC of 1/2 leads to a multiplier of only 2. Thus, a larger MPC means a larger multiplier. To see why this is true, remember that the multiplier arises because higher income induces greater spending on consump- tion. The larger the MPC is, the greater is this induced effect on consumption, and the larger is the multiplier.
OTHER APPLICATIONS OF THE MULTIPLIER EFFECT
Because of the multiplier effect, a dollar of government purchases can generate more than a dollar of aggregate demand. The logic of the multiplier effect, how- ever, is not restricted to changes in government purchases. Instead, it applies to any event that alters spending on any component of GDP—consumption, invest- ment, government purchases, or net exports.
For example, suppose that a recession overseas reduces the demand for U.S. net exports by $10 billion. This reduced spending on U.S. goods and services de- presses U.S. national income, which reduces spending by U.S. consumers. If the marginal propensity to consume is 3/4 and the multiplier is 4, then the $10 billion fall in net exports means a $40 billion contraction in aggregate demand.
As another example, suppose that a stock-market boom increases households’ wealth and stimulates their spending on goods and services by $20 billion. This ex- tra consumer spending increases national income, which in turn generates even more consumer spending. If the marginal propensity to consume is 3/4 and the multiplier is 4, then the initial impulse of $20 billion in consumer spending trans- lates into an $80 billion increase in aggregate demand.
The multiplier is an important concept in macroeconomics because it shows how the economy can amplify the impact of changes in spending. A small initial change in consumption, investment, government purchases, or net exports can end up having a large effect on aggregate demand and, therefore, the economy’s production of goods and services.