ASAD - The Spending Multiplier (Lesson)

The Spending Multiplier

Introduction

One of the key claims of great economists was the existence of an “expenditure multiplier.” Remember from previous readings that aggregate demand was highly volatile, that even if the economy started at a level of GDP where equaled it’s potential so that the economy was at full employment, AD could shift abruptly causing a recessionary or inflationary gap. In the previous model, not only did changes in spending cause GDP to change, but the change in GDP was more than proportionate than the initial change in autonomous spending. In other words, aggregate demand is powerful since a change in spending results in a multiplied change in GDP. This spending multiplier was part of the reasoning behind the view that fiscal policy is a powerful tool for managing the economy.

 

So What is the Spending Multiplier?

An initial change in any of the components of aggregate demand (AD) will lead to further changes in the economy and an even larger final change in real gross domestic product (GDP). That is, any initial change in spending will be multiplied as it impacts the economy. The final impact of an initial change in spending can be calculated using the spending multiplier. The size of the final impact of an initial change in spending on real GDP is affected by the amount of additional spending that results when households receive additional income, called the marginal propensity to consume, or MPC. The MPC is the key to understanding the multiplier, so the first step in understanding the multiplier is understanding the MPC.

Watch the video below to begin your study of the MPC.

 

 

 

The MPC, MPS, APC & APS....

The marginal propensity to consume (MPC) is the change in consumption divided by the change in disposable income (DI). It is a fraction of any change in DI that is spent on consumer goods (C): MPC = change in C/ change in DI.

The marginal propensity to save (MPS) is the fraction saved of any change in disposable income. The MPS is equal to the change in saving divided by the change in DI: MPS = change in S/ change in DI.

The MPC measures changes in consumption when income changes. The MPC is distinct from the average propensity to consume (APC), which measures the average amount of the total income households spend or save.

The average propensity to consume (APC) is the ratio of C to disposable income, or APC = C/DI.

The average propensity to save (APS) is the ratio of savings (S) to disposable income, or APS = S/DI.

Use the color coded equations below to help in your understanding of these propensities.

 

Taken together, then, a fall in the price level means that the quantities of consumption, investment, and net export components of aggregate demand may all rise. Since government purchases are determined through a political process, we assume there is no causal link between the price level and the real volume of government purchases. Therefore, this component of GDP does not contribute to the downward slope of the curve.

Watch the presentation below to learn more about the spending multiplier.

 

 

Just as demand and supply yield the price and quantity of a particular product, Aggregate Demand (AD) & Aggregate Supply (AS) determine the macroeconomic equilibrium - price level (telling whether we have inflation), quantity of goods and services (real GDP), and, indirectly unemployment.

Watch the video below to learn how these all work together.

 

 

Review

Review what you have learned by completing the activity below.

 

In Summary . . .

A change in any component of aggregate demand shifts the aggregate demand curve. Generally, the aggregate demand curve shifts by more than the amount by which the component initially causing it to shift changes.

Suppose that net exports increase due to an increase in foreign incomes. As foreign demand for domestically made products rises, a country’s firms will hire additional workers or perhaps increase the average number of hours that their employees work. In either case, incomes will rise, and higher incomes will lead to an increase in consumption. Taking into account these other increases in the components of aggregate demand, the aggregate demand curve will shift by more than the initial shift caused by the initial increase in net exports.

 

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