-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]
-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]
-MPC + MPS = 1
-Change in GDP = Multiplier x Initial Change in Spending
-Multiplier = Change in GDP / Initial Change in Spending
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