Question

In: Economics

Explain why the total benefits to the local economy are higher when we use the simple...

Explain why the total benefits to the local economy are higher when we use the simple spending multiplier.  Specifically, what are we assuming about this city when we calculate benefits using the simple spending multiplier formula?

Solutions

Expert Solution

Multiplier: It measures the change in national income due to change in investment level. When there in increase in investment, national income rises by multiple of it.

Multiplier is calculated as Change in Income / Change in Investment.

Assume MPC = 0.8 and investment raised by 100 crores. It will directly raise the level of income by 100 crore as one person spending is another person income.

MPC = 0.8
Round Change in Investment Change in Income
1 100 100
2 - 100 * 0.8 = 80
3 - 100 * 0.8^2 = 64
4 - 100 * 0.8^3 = 51.2
- and so on...

Change in Income = 100 + 80 + 64 + 51.2 + ……..

Change in Y = Change in I + MPC * Change in I + MPC^2 * Change in I………………

Change in Y = Change in I (1 + MPC + MPC^2……)

Sum of geometric progression is:

Change in Y / Change in I = [1 / (1 – MPC)]

We can see from the above table that investment of 100 crores tends to raise total income by much more than 100 crores.

Assumptions of multiplier model are:

  • MPC is constant
  • No time lags in spending multiplier process
  • People always change their consumption when income changes.

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