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? How does it relate to the economy today?

Answer 1

- Changes in spending and changes in real GDP exhibits a direct relationship, where because of the increase in spending, GDP increases as there is more output in the economy generated via more consumption.

- Multiplier formula is given by 1 / 1 - MPC. When MPC is less, multiplier is also less. For example

MPC = 0.1. Multiplier = 1 / 1 - 0.1 = 1 / 0.9 = 1.1

MPC = 0.9. Multiplier is 1 / 1 - 0.9 = 1 / 0.1 = 10

Thus when multiplier is large, size of the MPC is also high as people spend more, there is a multiplier effect.

On the other hand, when multiplier is high, size of MPS (Marginal propensity to save) is less. People save more and the economy doesn't grow and increase in output as much when savings are high. For example.

MPS = 0.1. Multiplier = 1 / MPS = 1 / 0.1 = 10 Thus multiplier is more and MPS is less.

MPS = 0.9. Multiplier = 1 / MPS = 1 / 0.9 = 1.1. Size of the multiplier is less, while MPS is more.

- The logic is essentially that the more the marginal propensity to consume, more is the multiplier as the amount spent in the economy for example, leads to an increase in income which is more than the amount spent, for example if the MPC is 0.9. It means that multiplier effect is 10. For every $1 of income generated, the new income generated is $10.

- With respect to the economy today, there is more saving and less spending as people are unsure where the future growth is going to come from. Thus the multiplier effect will be low as saving is more and MPC is less.