Multiplier Effect

Multiplier Effect

• In a recession (or recessionary gap) the government should use

  expansionary

  ---

  fiscal policy which means

  lower

  ---

  taxes and/or

  higher

  ---

  government spending. This would cause Aggregate

  Demand

  ---

  to shift

  right

  ---

• In an economic boom (or inflationary gap) the inflation rate usually goes higher so the government should use

  contractionary

  ---

  fiscal policy which means

  higher

  ---

  taxes and/or

  lower

  ---

  government spending. This would cause Aggregate Demand to shift

  left

  ---

• Multiplier effect - the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending. Example: Let's say government spending increases by $5 million on roads and bridges, now that the construction workers income increases, they spend an extra $5 million on consumption so the AD will shift right by

  $10

  ---

  million.

Multiplier Equations

• Marginal Propensity to Consume (MPC) - the proportion you will spend on consumption for every extra dollar earned in income.
• Marginal Propensity to Import (MPI or MPM or m) - the proportion you will spend on imports for every extra dollar earned in income.
• Tax Rate (t) - the proportion of every dollar earned in income that is paid in taxes.

• The bigger the MPC or the smaller the MPI (MPM) the

  bigger

  ---

  the spending multiplier. If there was a closed economy the multiplier would be

  bigger

  ---

  than what it would be with an open economy.