THE MULTIPLIER MODEL

Prepared by: RSEL

Samuelson & Nordhaus. Economics. 17th ed. Chapter 24

 THE BASIC
MULTIPLIER MODEL
What exactly is the Multiplier Model?
It is a Macroeconomic theory used to explain how
output is determined in the short-run.

The name “multiplier” comes from the finding that

each dollar change in exogenous expenditure
leads to more than a dollar change in GDP.

It explains how shocks to investment, foreign trade

and government tax & spending policies can affect
output and employment in an economy.
Key Assumptions:
Wages and prices are fixed
There are unemployed resources
We suppress the role of monetary policy
We assume that there are no financial market
reactions to changes in economy
First Approach:
OUTPUT DETERMINATION WITH
SAVING AND INVESTMENT

How investment and saving are

equilibrated in the multiplier model?
Recall:
Consumption Function Savings Function
Consumption Function
Each point on the
consumption function
shows desired or planned
consumption at that level
of disposable income.
Saving Function
Each point on the saving
schedule shows desired or
planned saving at that
income.

The two schedules are close

related since C+S = DI.

They are mirror twins that

will always add up to the 45°
line.
Savings and Investment
Depends on different factors:

Savings Investment
◊ Disposable Income ◊ Output
◊ Interest rates
◊ Tax policies
◊ Business Confidence

Investment as an exogenous variable –determined

outside the model.
 At this level of output,
Assume the investment will desired S of HH equals
be exactly the same per year desired I of Firms
regardless of the level of GDP.

This will mean it is a

horizontal line.

The saving & investment

schedules intersects at pt. E.
This corresponds to a level of
GDP given at pt. M &
represents equilibrium level
of output in the multiplier
model. At equilibrium: No inventories piling up on
their shelves, nor will their sales be so brisk as to
force them to produce more goods.

Production, employment, income, spending will

remain the same.
 Disequilibrium
GDP is higher than E
At point A, GDP is to the right of
M at an income level where the
saving schedule is higher than the
investment schedule.

HH: Saving > F: Investment

What will happen?

Firms will have too few customers
and larger inventories of unsold
goods.

What to do?
Cut production  lay off workers
 GDP  equilibrium.
Second Approach:
OUTPUT DETERMINED BY
TOTAL EXPENDITURES

TOTAL EXPENDITURE
TE = Consumption Function +
desired investment (C+I)
Total desired Expenditure (TE) –
desired expenditure of consumers &
businessmen at each level of output

At any point on the 45° line, total

desired expenditure is equal to
total desired output.

The economy is equilibrium if

TE crosses the 45° line, in this
case point E.

At point E, the level of desired

expenditure on consumption
and investment is equal to the
level of total output. Consumption Function – desired
consumption at each level of income
Where is the MULTIPLIER
in this?
To answer the question…
We need to examine how a change in exogenous
investment spending affects GDP.

We all know that an increase in investment will

increase level of output and employment.

But by how much?

Multiplier
Impact of a 1-dollar change in exogenous expenditures
on total output.

In the simple C+I model, the multiplier is the ratio of

the change in total output to the change in investment.

Example:
An increase in investment by P100B, can cause an
increase in output of P300B, thus the multiplier is 3.
Suppose we hire carpenters to build a waiting shed that
costs $ 1000.
(1) This carpenters will earn an extra income of $1000.
(2) If they have MPC of 2/3, they will now spend
$666.67 on new consumption goods.
(3) The producer of this goods, will now have an
income of $666.67.
(4) If their MPC is also 2/3, they will spend $444.44
or 2/3 of $666.67.
(5) The process will go on with each round of
spending being 2/3.
This will result to an endless chain of secondary consumption
spending which is set in motion by the primary investment of
$1000. Eventually it adds up to a finite amount.
Using arithmetic:
$1000 1 x $1000
+ +
$666.67 2/3 x $1000
+ +
$444.44 (2/3)² x $1000
+ = +
$296.30 (2/3)³ x $1000
+ +
197.53 (2/3)⁴x $1000
+ +
…____…
$3,000 1 x $1000, or 3 x $1000
1- 2/3
This shows that, with an MPC of 2/3, the multiplier is
3; it consist of the 1 of primary investment plus 2
extra of secondary consumption spending.

The size of the multiplier thus depends upon how large

is the MPC.

It can also be expressed in terms of the twin concept, the

MPS. If MPS is ¼, the MPC is ¾ , and the multiplier is 4.

Multiplier Formula: 1 x change in investment

1 - MPC
 Can we get the same result using the graphical analysis of
saving and investment?
Change in New equilibrium
Investment

Yes. Suppose the change in

investment is $100B, MPS is
1/3, therefore, multiplier is
3. What will be the new
equilibrium GDP? The
answer is $3,900B.

Increase in income is exactly 3

times the increase in investment.
FISCAL POLICY IN THE
MULTIPLIER MODEL
Fiscal Policy
Instrument in deciding how the nation’s output
should be divided between collective and private
consumption and how the burden of payment for
collective goods should be divided among the
population.

This has impacts on the short-run movements of

output, employment & prices.
HOW GOVERNMENT FISCAL POLICIES
AFFECTS OUTPUT?
New Total Expenditure
To understand the role of government in economic
activity, we need to look at government purchases
and taxation, along with the effects of those activities
on private sector spending.

We now modify our earlier analysis by adding G to C+I.

TE = C+I+G  New Total Expenditure: this can now

describe the new equilibrium when government, with
its spending and taxing, is in the picture.
 Consumption Changes when TAXES are present
The consumption function
changes when taxes are present.

In the original CF, GDP = DI;

Decrease
3,000=3,000. in Income

With introduction of taxes

amounting to 300, at DI of Original CF
3,000, GDP = 3,300

200 is the result of multiplying a Tax

decrease in income of 300 times CF with Tax
MPC 0f 2/3.
 Effects of including government purchases
This figure is just like the previous
diagrams. Here we added a new
expenditure stream, G, to the New equilibrium
consumption & investment. when G is added

We place this on top of C+I.

Why?
1. It has same macroecon impact as
spending on private buildings.
2. Collective expenditure involve in
buying government vehicle.
3. Has same effect on jobs as private
consumption expenditures on
automobiles.
Impact of Taxation on Aggregate Demand
Extra taxes lower DI reduce consumption spending.

If investment and government purchases remain the

same, a reduction in consumption spending will then
reduce GDP & employment.

Thus, in the multiplier, higher taxes without

increase in government spending will reduce real
GDP.
FISCAL-POLICY
MULTIPLIERS
The multiplier analysis shows that government
fiscal policy is high powered spending much like
investment.

It should have a multiplier effects upon output.

Government Expenditure Multiplier
An increase in GDP resulting from an increase of $1
in government purchases of goods & services.

An initial government purchase of a good or service

will set in motion a chain of spending.

If government builds a road, the road-builders will

spend some of their incomes on consumption goods,
which in turn will generate additional incomes, some
of which will be spent.
The ultimate effect of on GDP of an extra dollar of G
will be the same as the effect of an extra dollar of I.
The multipliers I equal to 1
An increase of $100B in G will 1-MPC
have an ultimate increase in
GDP equal to $100B primary
spending times the
expenditure multiplier.

In this case, because MPC = 2/3,

the equilibrium level of GDP
is $300B.

This example tells us that Gov’t

expenditure multiplier is the
same as the investment
multiplier.

They are both EXPENDITURE

multiplier.
 Tax Multiplier
Taxes also have an impact upon the equilibrium GDP,
although it is tax multiplier is smaller than
expenditure multipliers.

Thus, offsetting an increase in government purchases

requires an increase in tax larger than the increase
in G.

Tax multiplier = MPC x expenditure multiplier

Multipliers in Action
A realistic understanding of the size of multipliers is a
crucial part of diagnosis and prescriptions in economic
policy. (like physicians must know the effect of different
dosages of their medicines).

They have to know the magnitude of expenditure and tax

multipliers.

When economy is growing too rapidly and a dose of fiscal

austerity is prescribed, the economic doctor needs to know
the actual size of multipliers before deciding how large
a dose of tax increases or expenditure reductions to
order.
Beyond the Multiplier Model
Macroeconomics understanding requires
understanding not just the models but also their
strengths and weaknesses.
Among the simplifications of the simplest multiplier
model are the following:
 The MM ignores the impact of money and credit
upon consumption & investment.
 The simplest MM ignores the way foreign trade affects
output at home & abroad.
 Aggregate supply is left out of the story, so we have no
way of analyzing how increases in spending are divided
between prices and output.
END