Question

1) Give the intuition behind the multiplier. Give examples of activities that you suspect might produce a small multiplier effect and another that you think might produce a large multiplier effect.

2) Using the simple household model, C = c_o + c₁ (Y-t), assume that c_o is $1000, taxes are $1000, and is c₁ .5. What would be the impact on consumption spending if household incomes were to rise by $500? (Ignore the multiplier effects here.) What about if taxes were to fall to $50?

Answer 1

1) When an initial change in aggregate demand leads to a much greater final impact on the level of equilibrium national income it is called as the multipler process. It happens because one person’s spending is another’s income and thatleads to a greater impact on output and employment. The multipler effect is large in the cases where the marginal propensity to spend on goods and services is high for instance for necessities. In case when the marginal rate of tax on extra income is low, the propensity to spend extra income rather than save is high, the Consumer confidence is high (this affects willingness to spend gains in income) or when the business in the economy have the capacity to expand production to meet increases in demand, the multipler effect is large. On the other hand, larger marginal propensity to import will decrease the multipler effect.