Question

Is the relationship between changes in spending and changes in real GDP in the multiplier effect a direct (positive) relationship or is it an inverse (negative) relationship? How does the size of the multiplier relate to the size of the MPC? The MPS? What is the logic of the multiplier-MPC relationship?  (answer in your own words)

Answer 1

The changes in spending and changes in real GDP in the multiplier effect is a direct relationship. In other words, with respect to multiplier effect, an increase in spending leads to increase in real GDP and a decrease in spending leads to decrease in real GDP.

The size of multiplier relates to the size of the MPC in the sense the lower the value of MPC, smaller will be the value of multiplier and higher the value of MPC, greater will be the value of multiplier. So, there exist a direct relationship between size of MPC and size of multiplier.

The size of multiplier relates to the size of the MPS in the sense the lower the value of MPS, greater will be the value of multiplier and higher the value of MPS, smaller will be the value of multiplier. So, there exist an indirect relationship between size of MPS and size of multiplier.

MPC indicates the proportion of additonal income that will be spent on consumption.

As additional income is spent on consumption, it creates more income and a consumption-income cycle gets started.

So, the logic of the multiplier-MPC relationship is that as proportion of income (determined by MPC) is spent on consumption, it leads to generation of more income leading to more consumption and income and would increase the total income (determined by multiplier) in the economy.

Thus, multiplier-MPC relationship states the ultimate increase in income within the economy due to an initial increase in aggregate expenditure.