14.1. The transmissions of shocks: The multiplier process
Sunday, 07 August 2022 20:20
Remember:
• How does the firm's and household's behaviour affect the economy?
We need a tool to understand how the impact of firms and households' investment spending decisions
will affect the whole economy, how large the direct and indirect impact of the change will be and/or
what the effect of lower government spending will be, etc.
• Changes in current income influence spending, affecting the income of others, SO indirect effects through the
economy amplify the direct effect of a shock to aggregate demand [AD].
THE MULTIPLIER
The multiplier represents the relative magnitude of total change in output as a result of an initial change in spending.
:. If R1 is spent in the economy, by how much will that R1 change the real GDP of that economy?
Multiplier effect
• The total change in output can be greater than the initial change in C or I because of the circular flow of
expenditure, income, and output.
• If the multiplier = 1: the increase in real GDP is equal to the initial increase in spending.
• If the multiplier <[>] 1: the total increase in real GDP is less/more than the initial increase in spending.
Multiplier process
• The multiplier process helps us to explain why real GDP increases more than the initial increase in spending
[investment].
• The process is explained through the aggregate consumption function = consumption spending [C] for the
economy as a whole combining the behaviour of consumption smoothing and non-consumption smoothing
households.
○ Consumption depends on income.
○ For consumption smoothing households: an increase in income will not increase their consumption one-
for-one, or even at all.
○ Non-smoothing households will increase their current consumption one-for-one in response to a
temporary increase in their income.
○ The multiplier is > 1, if the addition consumption spending resulting from a temporary increase in income
is greater than zero but less than 1.
Unit 14 Page 1
, 14.2. Multiplier model [Consumption]
Thursday, 01 September 2022 08:05
Remember
Figure 13.6. The circular flow model
A simple model:
- Private economy
- Two sectors
Households [C]
Firms [I]
Multiplier mode: Consumption function [C]
Consumption dependent on the
income - the variable amount
Autonomous consumption is the [disposable] income
fixed amount spent, independent
of the income.
MPC is the marginal propensity to
consume [used when we are credit-
constrained :. Weakness of will]
Multiplier model: Aggregate consumption
...
- Autonomous consumption
- Fixed amount spent, independent of the income
Expectations about the future income are reflected in autonomous consumption.
...
- Consumption dependent on the income :. the variable amount
- e.g. If marginal propensity to consume is 0.6 then consumption increases by 60c.
Figure 14.2. The aggregate consumption function.
Unit 14 Page 2
, The slope of the consumption function (c1) is the marginal propensity to consume [MPC], the change in consumption when
disposable income changes by one unit. MPC is positive, but < 1: shift in change in c1 variable, shift upwards.
:. Part of the income is consumed, the rest will be saved.
PART OF INCOME IS CONSUMED AND THE REST IS SAVED
Part of income Part of income
consumed = MPC saved = MPS
MPS - Marginal propensity to save is
the change in savings when disposable
MPC + MPS = 1
income changes by one unit.
Consumption function
- A steeper consumption line means a larger consumption response to a change in income. [Greater MPC]
- A flatter line means that households are smoothing their consumption so that it does no vary much when incomes
varies.
▪ Smaller MPC
▪ Through self-insurance or co-insurance
▪ Not so sensitive to changes in income
We want households to have a flatter line, because then it's not so volatile.
Unit 14 Page 3
Sunday, 07 August 2022 20:20
Remember:
• How does the firm's and household's behaviour affect the economy?
We need a tool to understand how the impact of firms and households' investment spending decisions
will affect the whole economy, how large the direct and indirect impact of the change will be and/or
what the effect of lower government spending will be, etc.
• Changes in current income influence spending, affecting the income of others, SO indirect effects through the
economy amplify the direct effect of a shock to aggregate demand [AD].
THE MULTIPLIER
The multiplier represents the relative magnitude of total change in output as a result of an initial change in spending.
:. If R1 is spent in the economy, by how much will that R1 change the real GDP of that economy?
Multiplier effect
• The total change in output can be greater than the initial change in C or I because of the circular flow of
expenditure, income, and output.
• If the multiplier = 1: the increase in real GDP is equal to the initial increase in spending.
• If the multiplier <[>] 1: the total increase in real GDP is less/more than the initial increase in spending.
Multiplier process
• The multiplier process helps us to explain why real GDP increases more than the initial increase in spending
[investment].
• The process is explained through the aggregate consumption function = consumption spending [C] for the
economy as a whole combining the behaviour of consumption smoothing and non-consumption smoothing
households.
○ Consumption depends on income.
○ For consumption smoothing households: an increase in income will not increase their consumption one-
for-one, or even at all.
○ Non-smoothing households will increase their current consumption one-for-one in response to a
temporary increase in their income.
○ The multiplier is > 1, if the addition consumption spending resulting from a temporary increase in income
is greater than zero but less than 1.
Unit 14 Page 1
, 14.2. Multiplier model [Consumption]
Thursday, 01 September 2022 08:05
Remember
Figure 13.6. The circular flow model
A simple model:
- Private economy
- Two sectors
Households [C]
Firms [I]
Multiplier mode: Consumption function [C]
Consumption dependent on the
income - the variable amount
Autonomous consumption is the [disposable] income
fixed amount spent, independent
of the income.
MPC is the marginal propensity to
consume [used when we are credit-
constrained :. Weakness of will]
Multiplier model: Aggregate consumption
...
- Autonomous consumption
- Fixed amount spent, independent of the income
Expectations about the future income are reflected in autonomous consumption.
...
- Consumption dependent on the income :. the variable amount
- e.g. If marginal propensity to consume is 0.6 then consumption increases by 60c.
Figure 14.2. The aggregate consumption function.
Unit 14 Page 2
, The slope of the consumption function (c1) is the marginal propensity to consume [MPC], the change in consumption when
disposable income changes by one unit. MPC is positive, but < 1: shift in change in c1 variable, shift upwards.
:. Part of the income is consumed, the rest will be saved.
PART OF INCOME IS CONSUMED AND THE REST IS SAVED
Part of income Part of income
consumed = MPC saved = MPS
MPS - Marginal propensity to save is
the change in savings when disposable
MPC + MPS = 1
income changes by one unit.
Consumption function
- A steeper consumption line means a larger consumption response to a change in income. [Greater MPC]
- A flatter line means that households are smoothing their consumption so that it does no vary much when incomes
varies.
▪ Smaller MPC
▪ Through self-insurance or co-insurance
▪ Not so sensitive to changes in income
We want households to have a flatter line, because then it's not so volatile.
Unit 14 Page 3
