Question

How can initial changes in spending ultimately produce multiplied changes in GDP?

Answer 1

The initial changes in spending can produce multiple changes in GDP through a phenomenon called demand multiplier in economics literature.

Let's understand this with an example.

Consider an economy with GDP of 1000 and marginal propensity to consume is 0.75. Now let's suppose there is an increase in spending by 100 by the government.

Now what will happen due to this?

As government spend this $100 this will earned by someone as an income. And then that person will consume or spend 0.75 proportion of 100 since the marginal propensity to consume in this economy is 0.75. And 0.75 of 100 is equal to 75. So this person will spend 75. And now this 75 will be earned by someone else. And. Again that person will spend 0.75 proportion of 75 which is equal to, 0.75 × 75 = 56.25.

And now this 56.25 will be earned by another person as an income, and he will spend 0.75 proportion of this 56.25 which will be equal to 0.75×56.25 = 42.1875. And this will be earned by another person in the economy and he then will spend 0.75 proportion of this amount which will be equal to 0.75×42.1875 = 31.64.

And this process of demand creation will keep on going, as you see the initial change in spending by 100 by the government has brought about a series of increase in demand and GDP.

And there is special name for the series that it forms, look at the series,

100 + 75 + 56.25 + 42.18 + 31.64 +........... +

As you can see this is infinite geometric progression with,

a = initial term = 100

r = common difference = 75/100 = 0.75 which is nothing but the marginal propensity to consume.

And the sum of infinite GP is given by the formula,

= a/ 1 - r

When r < 1 which is the case here.

Putting the values in the formula we get,

= 100/1 - 0.75

= 100/0.25

= 400

So as you can see the initial change in spending by $100 has brought about a change of $400 in GDP through demand multiplier.

And the formula for demand multiplier is given by,

= 1/MPC

Here MPC = marginal propensity to consume.