Question

1. a) What is Multiplier? Explain how it works in an economy. 4
b) Explain the paradox of thrift. Why do you think it is a paradox? 3
c) Suppose the consumption function is given by C=300+0.75Y while
investment spending is 900 with no govt. expenditure. 3
i. Determine the equilibrium level of national income and consumption
expenditure.
ii. If investment spending increases to 1100, what will be the effect on
equilibrium income?
iii. If the government desires to increase the national income level by
$1200 billion from its equilibrium value, what should be the change in
investment spending?

Answer 1

a) A multiplier is the factor by which an outcome increases when a fator affecting it is changed. In case of macroeconomics, multiplier is usually used in terms of change in national income or national output when any factor like consumption, investment or government expenditure changes. When there are changes in autonomous consumption (consumption multiplier), or investment ( investment multiplier) or fiscal policy changes like increase/decrese in government expenditure or taxes (fiscal multiplier), the change in equilibrium output may be more or less or equal to the proportional change in these factors depending on if the value of multiplier is greater or less or equal to 1, respectively. Multiplier was used by Keynes to explain the business cycles.

b) paradox of thrift was a concept given by John Maynard Keynes that explains that in individuals tend to increase saving during recession. However, higher private saving implies lower consumption leading to lower aggregate demand and hence, lower national output. This in turn leads to lowering the national saving due to lower equilibrium output. Hence, the paradox is that the aim of the action was to increase saving but it may actually lead to a fall in total saving.