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Aggregate Expenditures: The multiplier Unit 3 Krugman Section 4 Module 21 Rationale of the Multiplier The economy has continuous flows of expenditure & income—ripple effect Income received by person A comes from $ spent from person B. The fraction of the change in income that is spent is called the MPC The fraction of the change in income that is saved is called the MPS The Multiplier Effect Small change in investment leads to a large change in output and income. The multiplier determines how large the change will be Multiplier = change in GDPr / initial change in spending Ex. A $5 billion change in Ig led to a $20 billion change in GDP. What is the multiplier? 4 Multiplier & Marginal Propensities The size of the MPC and the multiplier are directly related The size of the MPS & the multiplier are inversely related Spending Multiplier M = 1 / MPS or M = 1 / (1-MPC) Tax Multiplier -MPC/MPS OR -MPC/ (1-MPC) **note the negative sign (when the G taxes, we have less DI = less C) Significance of the Multiplier A small change in investment plans or consumption savings plans can trigger a much larger change in the equilibrium level of GDP Magic of the Multiplier Packet Check for understanding: What could happen to C, Savings and/or DIg? The multiplier? 1. The threat of war, leads the public to expect future shortages of durables. (C,S,M) 2. A decline in the real interest rate. (all) 3. A sharp, sustained decline in stock prices. (C,S,M) 4. The development of a cheaper method of manufacturing computer chips. (Ig,M) 5. A sizable increase in the retirement age for collecting social security benefits. (C,S,M) 6. The expectation of an increase in the CPI for the next two years. (C,S,M) 7. The overall feeling of the nation is one of optimism. (all) 8. An increase in the federal income tax. (C,S,M) 1. The threat of war, leads the public to expect future shortages of durables. (C,S) C increase S decrease Multiplier would increase 2. A decline in the real interest rate. (all) Ig increase (movement) C increase S decrease Multiplier would increase 3. A sharp, sustained decline in stock prices. (C, S) C decrease S increase Multiplier would decrease 4. The development of a cheaper method of manufacturing computer chips. (Ig) Ig increase (technology) Multiplier would increase 5. A sizable increase in the retirement age for collecting social security benefits. (C,S) C decrease S increase Multiplier would decrease 6. The expectation of an increase in the CPI for the next two years. (C,S) C increase S decrease Multiplier would increase 7. The overall feeling of the nation is one of optimism. (all) C increase S decrease Ig increase Multiplier would increase 8. An increase in the federal income tax. (C,S) C decrease S decrease **the exception to the increase of one means the decrease of the other** Multiplier would decrease