![]() ![]() Table 1 works through the process of the multiplier. $81 of income to people through the economy: Save 10% of income. ![]() $90 of income to people through the economy: Save 10% of income. Original increase in aggregate expenditure from government spending The table below gives an example of how this could work with an increase in government spending. Note that the multiplier works the same way in reverse with a decrease in spending. When the dust settles the amount of new income generated is multiple times the initial increase in spending–hence, the name the spending multiplier. The process continues, though because economic agents spend only part of their income, the numbers get smaller in each round. Those purchases then become new income to the sellers, who then turn around and spend a portion of it. That spending becomes someone else’s income. Each of these economic agents takes their new income and spend some of it. Any income left over is profit, which becomes income to their stockholders. They use that income to pay their bills, paying wages and salaries to their workers, rent to their landlords, payments for the raw materials they use. The producers of those goods and services see an increase in income by that amount. Suppose government spontaneously purchase $100 billion worth of goods and services, perhaps because they feel optimistic about the future. It’s easiest to see how the multiplier works with an increase in expenditure. How Does the Expenditure Multiplier Work? You can view the transcript for “Macro Minute - The Multiplier Effect” here (opens in new window). Watch this video for a quick overview of the expenditure multiplier. This is called the expenditure multiplier effect: an initial increase in spending, cycles repeatedly through the economy and has a larger impact than the initial dollar amount spent. In this way, the original change in aggregate expenditures is actually spent more than once. The reason is that a change in aggregate expenditures circles through the economy: households buy from firms, firms pay workers and suppliers, workers and suppliers buy goods from other firms, those firms pay their workers and suppliers, and so on. Or to say it differently, the change in GDP is a multiple of (say 3 times) the change in expenditure. ![]() It turns out that changes in any category of expenditure (Consumption + Investment + Government Expenditures + Exports-Imports) have a more than proportional impact on GDP. You might expect the result would be that GDP would fall by $100 billion too. But how much did GDP fall? Suppose investment fell by $100 billion. investment expenditure collapsed with the fall of the housing market. Keynes pointed out that even though the economy starts at potential GDP, because aggregate demand tends to bounce around, it is unlikely that the economy will stay at potential. Suppose that the macro equilibrium in an economy occurs at the potential GDP, so the economy is operating at full employment. You’ve learned that Keynesians believe that the level of economic activity is driven, in the short term, by changes in aggregate expenditure (or aggregate demand). Keynesian economics has another important finding. Compute the size of the expenditure multiplier. ![]() Explain the expenditure multiplier effect. ![]()
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