Introduction
-The multiplier effect: a small change in spending will yield a much larger change in GDP.
-If someone increased their spending by $1, the economy’s GDP would increase by more than $1.
-To understand the logic behind this, let’s take a look at an example.[break]
Example:
Multiplier Effect Rationale

-Suppose a firm decided to increase their investment spending by $5.00. Let’s say that they chose to put that $5.00 towards constructing a new building. That means a construction worker is going to get $5.00 in income that he didn’t have before (change in income).
-Of this new $5.00, this construction worker is going to spend some of it and save some of it. If his marginal propensity to consume is 0.80, then of this new $5.00, he will spend $4.00 (change in consumption) and save $1.00 (change in savings).
-Suppose this construction worker takes the $4.00 and spends it at the liquor store down the street from his house. That means that the store owner now has an extra $4.00 in income that he didn’t have before.
-The store owner is going to spend 80% of it ($3.20) and save 20% of it ($0.80).
-The $3.20 that the store owner spends is going to turn into someone else’s income, which in turn leads to more spending which leads to more income.
-If we execute this over many transactions and sum all the numbers, we find that in this scenario, a $5.00 initial increase in spending will lead to a total of a $25.00 change in income, aka GDP.
-The reason why the multiplier effect exists is because one person’s spending is another person’s income
-Opposite scenario: If spending was cut by $5, GDP decreases by $25.[break]
Formulas
-MPC + MPS = 1
Multiplier = \frac{1}{1-MPC} or Multiplier = \frac{1}{MPS}
-Change in GDP = Multiplier  x Initial Change in Spending
-Multiplier = Change in GDP / Initial Change in Spending

Disclaimer

All works here are my own and are considered works in progress and may be subject to change at any time. The opinions expressed here are mine only unless otherwise noted. I am not being paid by a third party to endorse a product of any sort. These writings are written for my own references. I do not claim to be a professional of any kind so follow any information you find here at your own risk. The facts that I post on here are things that I believe to be true, but may not necessarily be so. This is the internet; do your own fact checking and take everything with a grain of salt.

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