Question

How an increase in each of the following may cause a much larger (multiplied) affect on consumption and GDP:

1. Government Expenditure

2. Investment

3. Net Exports

Answer 1

1. An increase in government expenditure will have a multiplied effect on output. This is because this will be multiplied with the multiplier given by 1/(1-mpc) where mpc is the marginal propensity to consume. Thus if government spending rise by G then the impact on output will be given by G/(1-mpc). This is the net effect on output of the rise in government spending. Also as output rises the consumption will increase by mpc*Y.

2. As investment rises then the rise in output will be given by I/(1-mpc). This is the final impact on output which will be greater when the mpc is higher. As output rises then the consumption will increase by mpc*Y. Then the multiplicative effect on output depends on the marginal propensity to consume.

3. Net exports is given by the difference between exports and imports. Now as exports rise then the output will rise again by the multiplier depedning on th marginal propensity to consume. The impact on imports will be effected by the marginal propensity to import and that determines the impact on output. The amount consumption rises depends on the marginal propensity to consume.