An initial change in AE can have a greater final impact on equilibrium national income. This is known as the multiplier effect and it comes about because injections of demand into the circular flow of income stimulate further rounds of spending.
Consider a $300 million increase in business capital investment. This will set off a chain reaction of increases in expenditures. Firms who produce the capital goods that are ultimately purchased will experience an increase in their incomes. If they in turn, collectively spend about 3/5 of that additional income, then $180m will be added to the incomes of others. At this point, total income has grown by ($300m + (0.6 x $300m). The sum will continue to increase as the producers of the additional goods and services realize an increase in their
incomes, of which they in turn spend 60% on even more goods and services. The increase in total income will then be ($300m + (0.6 x $300m) + (0.6 x $180m). The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow.
The value of the multiplier can be found by the equation 1 ÷ (1-MPC)
You can also use the following formula which represents a four sector economy
1 ÷ MPS+MRT+MPM
MPS = Marginal propensity to save
MRT = Marginal rate of tax
MPM = Marginal propensity to import
MPC = Marginal Propensity to Consume (of additional income how much of it spent)
e.g. $1m initial spending; MPC=.8
=> income generated = 1/(1-.8) = 1/.2 = 5
=> $4m extra spending ($1m initial, $4m extra spending, $5m total)
Use different equations depending on the information given.
e.g.: a) if the MPC is 0.5 – 50% of the income will be spent, 50% will be saved.
then MPS is 0.5 then the multiplier is 2 = 1/0.5 = 2
b) if the MPC is 0.8 – 80% of the income will be spent then MPS is 0.2 then the multiplier is 1/0.2 = 5
c) if the MPC is 0.9 – 90% of the income will be spent then MPS is 0.1 then the multiplier is 1/0.1 = 10
What is the effect of MPT – the marginal propensity to tax or t.
- greater MPT would lead to less income being spent in the economy
Below is a very informative mind map that I copied from an old textbook.