704 The Multiplier Effect

12538The multiplier effect occurs when a million dollars, for example, of expenditure generates more than a million dollars worth of income for the rest of the population. You might be wondering, how does this happen?

Take for example a rich man who spends a million dollars on a new Lamborghini. This one million dollars is of revenue to Lamborghini is paid to its employees in salaries. Each worker, say we’re only talking about the production workers, gets paid about $2000. Then each worker takes his $2000 and they go out to have a good time together at a club. The bar tender then gets paid for his service, maybe about $3000 a month, he’s an awesome bar tender. Then this bar tender decides to have a big feast with his family, so he takes his family to a restaurant and pays $1000 for a freakin big and good meal! So the chef gets paid.

This story can go on and on but it finally stops when the initial 1 million dollars spent by the rich man has seen its limit to this multiplication effect. To summarize, every one dollar spent generates more than one dollar of income. And how much income is generated out of this dollar spent is determined by the economy’s multiplier. You will learn that factors such as the marginal propensity to consume as well as proportional taxes affect the multiplier of the economy.

At the end of this video, you should be able to:

  • Understand how the AE curve rotates in relation to a bigger or smaller multiplier.
  • Derive the multiplier from the AE equation at equilibrium.
  • Determine what variables change the multiplier.

 

 

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11 Comments

  1. Alfred says:

    hello i am confused as to how you derived y=1:(1-C1) Abar from Y(1-C1)= Abar. I know it is probably correct but I cant follow the algebra. May you clarify. Thanks

    • Quickienomics says:

      Hi Alfred, what I did was to divide both sides of y(1-C1)=Abar by (1-C1), this would give me y=Abar/(1-C1). The right hand side is then similar to y=1/(1-C1).Abar.

      Hope that helps. 🙂

  2. Darika says:

    Hey! I’m kind of confused in the last bit of the video.. where you said that MPC of poor is greater than that of the rich. can you please explain why is it so ?

    • Quickienomics says:

      That’s because most of their disposable income will be used on meeting their daily needs. Due to their relatively lower income, they will be able to save lesser of their disposable income. Therefore, their MPC will be larger.

  3. Brian says:

    Hey man, can i confirm the algebra for proportional tax multiplier as C0 + [(C1-C1.t)Y] + I + G = Y , therefore A = Y – [C1(1-t)Y] therefore taking out the Y, in the end Y[1-C1(1-t)1] = A. Lastly, Y = A/ [1-C1(1-t)]

    • Quickienomics says:

      Hey Brian, yea I just wrote out the equation. You got it right. 🙂 Keep it up man!

  4. Kim says:

    How come you so clever?

  5. stas says:

    Hi again, I am just watching this video and I am a little confused around the point where you describe the example of multiplier effect for the proportional taxes. How come the government spending is G=G0? In the previous video you’ve mentioned that for proportional tax, the government spenditure will be G=tY. So if we use that, tY would not be a part of Autonomous spenditure, but rather a part of the multiplier? Thanks a lot!

    • Quickienomics says:

      Hi, government expenditure was G=tY because of balance budget policy. G=Go means no balance budget policy.

  6. Strongbow says:

    When u say income gap increases..
    Doesnt it mean that (alpha) actually becomes smaller?

    Lets say alpha is at 0.3 initially.
    Poor people earns 0.3Y and rich people earns 0.7Y, so now the income gap is 0.4(alpha)

    If income gap increases, should alpha decrease to lets say 0.2 instead?
    So now poor people earns 0.2Y and rich people earns 0.8Y increasing the income gap to 0.6(alpha)?

    Or is should i just swallow what u have taught me so i can shut down my brain that thinks too much?

    Thanks for clarification! Cheers!

  7. Bon says:

    Hi, I’m confused because in the UoL intro to econ subject guide the multiplier is dY/dA that is 1/(1-c1) for lump sum tax. However you say it’s m=c1.