Question

Explain how an initial change in spending results in an increase in GDP that exceeds this change. Indicate the formula for both the expenditure multiplier and the tax reduction multiplier and explain why they are different. Explain how crowding out influences the expenditure multiplier. Explain how the multiplier concept is used in the banking system. Please answer these questions in 3 to 5 paragraphs.  

Answer 1

Change in spending, brings change in GDP and it happens due to interlinked events. When a person spends money to buy goods, then a demand is fulfilled, afterwards the person getting money becomes income and that income is spent again to buy other goods and spending here, becomes the income of others and process continues. It creates aggregate demand. Here, the spending by each person depends upon the marginal propensity to consume and multiplier effect is created. A bigger MPC, leads to bigger multiplier effect in the economy.

Expenditure multiplier = 1/(1-MPC)

Tax reduction multiplier = -MPC/(1-MPC)

Tax reduction multiplier is different from expenditure multiplier, because saved income due to lower tax are again subjected to the MPC. So, impact of tax reduction multiplier will be less than the expenditure multiplier.

Crowding out reduces the impact of expenditure multiplier. When crowding out takes place, then increase in spending is counter balanced by the decrease in investments by the firms. Hence, both the activities cancel each other and multiplier effect is not completely shown.

Multiplier effect is also used in the banking system and it is the money multiplier that is used to increase the monetary base and money supply in the economy. Here:

Money multiplier = 1/Required reserve ratio

When $10000 is deposited in the bank and required reserve ratio is 10%, then:

Total increase in money supply = 10000*(1/10%)

Total increase in money supply = $100000

It is the way, multiplier effect is set in the banking effect to increase or change the money supply in the economy.