Question

Explain the multiplier intuitively. Why is it that an increase in planned investment of $1,000 raises equilibrium output by more than $1,000?

Answer 1

A multiplier that exists in the aggregate expenditure model works due to the presence of marginal propensity to consume and marginal propensity to import. Since every increase in the autonomous spending increases the income directly in the first stage, accompained by subsequent increases in the income due to the marginal propensity to consume, there is a multiplier effect.

For example assume that there is a planned investment of $1,000. This will first increase the income by a direct value of $1,000. However this will increase the consumption further by MPC x 1000 and this will further increase the income. This process of increasing income and increase in consumption will continue till the entire multiplier process is completed. Due to these subsequent increases in income we expect that equilibrium output will be increased by more than $1,000. In this simple case the multiplier is 1/1-mpc.