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The Simple Multiplier Model

The Simple Multiplier Model

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Published by: Inderpreet Singh Saini on Nov 19, 2010

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11/05/2012

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The Simple Multiplier Model
Suppose a factory with a payroll of \$500,000 locates in a Lemmingville, a typical suburban community.Suppose further that the \$500,000 is the only money that the factory spends in the community, that allemployees live in Lemmingville, and that each person who lives there spends exactly one half of hisincome locally. By how much will the income of Lemmingville rise as a result of the new factory? The \$500,000 will be an addition to Lemmingville income. But the story does not end here because, byassumption, the people who earn the payroll will spend one half of the payroll, or \$250,000, in thecommunity. This \$250,000 will become income for the shopkeepers, plumbers, lawyers, teachers, etc. Thus Lemmingville income will rise by at least \$750,000. But the story does not end here either. Theshopkeepers, plumbers, etc. who received the \$250,000 will in turn spend one half of their new incomelocally, and this \$125,000 will become income for other people in the community. Total Lemmingvilleincome is now \$875,000. The process will continue on and on, and as it does, total income will approach\$1,000,000.Notice that the initial half million in income expands to one million once in the system. There is amultiplier effect that is similar to the multiplier effect in themodel of contingent behavior.The size of  the multiplier in our suburb depends on the percentage of income people spend within the community. The smaller the percentage, the more quickly the extra income leaks out of the economy and thesmaller the multiplier. The Keynesian multiplier model applies to the national economy the logic by which a new factory canincrease a town's income by a multiple of its payroll. Central in this model is an assumption about howpeople spend, the consumption function. The consumption function says that the amount people spenddepends on their income, and that as income increases, so does consumption. The table below illustrates a consumption function. It says that if people expect incomes of \$10,000,they will spend \$12,500. This amount of spending is possible if people plan to borrow or to dissave. (Todissave means to sell assets.) The table says that when expected income is \$30,000, people will spend\$27,500, which means that they plan to save \$2,500.

Table 1: A Consumption FunctionExpected IncomeConsumptionExpected Savings\$10,000\$12,500-\$2,50012,00014,000-2,00020,00020,000030,00027,5002,500 The table shows that if expected income rises by \$2,000, from \$10,000 to \$12,000, people will increasetheir spending by \$1,500, or that they will only spend three-fourths of additional income that theyexpect to receive. This fraction of additional income that people spend has a special name, themarginal propensity to consume (or mpc for short). In the table above the mpc is always three-fourths. Thus if income increases by \$8000, from \$12,000 to \$20,000, people increase spending by \$6,000, from\$14,000 to \$20,000. The marginal propensity to consume can be computed with the formula:(1) MPC = (change in consumption) divided by (change in income)In addition, economists often talk of the marginal propensity to save, which is the fraction of additionalincome that people save. Since people either save or consume additional income, the sum of themarginal propensity to save and the marginal propensity to consume should equal one. The value of the marginal propensity to consume should be greater than zero and less than one. Avalue of zero would indicate that none of additional income would be spent; all would be saved. A valuegreater than one would mean that if income increased by \$1.00, consumption would go up by morethan a dollar, which would be unusual behavior. For some people a mpc of 1 is reasonable, meaningthat they spend every additional dollar they get, but this is not true for all people, so if we want aconsumption function that tells us what people on the average do, a value less than one is reasonable. The consumption function can also be illustrated with an equation or a graph. The equation that givesthe consumption function in the table above is:(2) Consumption = \$5000 + (3/4)(Expected Income).If people expect an income of \$10,000, this equation says consumption will be:(3) Consumption = \$5000 + (3/4)(\$10000) = \$5000 + \$7500 = \$12500which is the same result that the table contains. Notice that one can see the marginal propensity toconsume in this equation. It is the fraction 3/4.

Graphing the consumption function presented above in the table and equation yields a straight line witha slope of 3/4 shown below. If the slope of the consumption function, which is the mpc, never changes,the consumption function is linear. If the mpc changes as income changes, then the consumptionfunction will be a curved line, or a nonlinear consumption function. The \$5,000 term in equation 2 isshown on the graph as the intercept, which indicates the amount of consumption if expected income iszero.When will this model be in equilibrium? To answer this, recall that spending by one person is income foranother. Because so far we have assumed that consumption is the only form of spending, the amount of consumption spending will equal actual income. If people expect income of \$10,000 and spend\$12,500, actual income will exceed expected income. It is reasonable to suppose that as a result peoplewill change their expectations, and thus their behavior. The logical equilibrium condition in this model isthat expected income should equal actual income.In the table we see that \$20,000 will be equilibrium income. When people expect income to be \$20,000,they act in a way to make their expectations come true. We can show the solution on a graph by addinga line that shows all the points for which actual income equals expected income. These points will forma straight line that will bisect the graph, shown below as a 45-degree line. Equilibrium income occurs inthe model when the spending line intersects the 45-degree line.It is relatively simple to addbusiness and government spendingto this model.
Investment and Government
Consumption is not the only type of spending; business spends in the form of investment, governmentspends, and the economy has transactions with other nations. The government also taxes. Makingthese adjustments to the model increases its complexity but does not change its logic.What assumption should we make about how business makes investment decisions? We could assumethat, like consumption spending, business investment decisions depend on expected income. The logicof theaccelerator principlesuggests this assumption. Or we could assume that the interest rate, whichmeasures the opportunity cost of tying up assets in the form of capital, should matter. However, we will

begin with the standard assumption in textbook treatments of the model: investment is determinedoutside the model, or in the jargon of economists, it is
exogenous
.In the table below we have added investment spending to the model. At an expected income of \$20,000, consumers will spend \$20,000 and expect to save nothing. Business will invest \$2,500. Thusactual income will be \$22,500 (and actual savings will be \$2,500, matching investment). Since actualincome will not equal expected income, expected income should change, causing behavior to changetoo. Not until expected income equals \$30,000 will expected income equal actual income and only thenwill behavior stop changing.
Table 2: The Simple Income-Expenditure Model withInvestment
ExpectedIncomeConsumptionExpectedSavingsInvestmentActualIncome\$10,000\$12,500-\$2,500\$ 2,500\$15,00012,00014,000-2,0002,50016,50020,00020,00002,50022,50030,00027,5002,5002,50030,000Notice that the addition of \$2,500 in investment increased the equilibrium from the \$20,000 to\$30,000. There is a multiplier effect here, and the multiplier is four. The reason for the multiplier effectcan be seen intuitively. As the result of the addition of the \$2,500 in investment, actual income rises by\$2,500. Expected income will also rise. But at the new expected income of \$22,500, people will want tospend more than \$20,000 for consumption, so there will be an additional
induced
increase in spending.But the story does not end here. The additional consumption increases actual and thus expectedincome, and changes behavior still further. The chain reaction that the addition of investment sets intoeffect diminishes at each step, and the total will approach \$30,000. This more complex model is illustrated graphically below. The only alteration is that the total spendingline now includes investment as well as consumption. As before, the equilibrium exists when expectedincome equals actual income. To complete the standard textbook model, we need to add government. Government affects the flow of spending in two ways: it adds spending in the form of government purchases of goods and services andit takes money from the flow of spending with taxes. Government purchases include payments forfighter planes, salaries of congressmen, and building of new highways. Not included in governmentspending are
transfer payments
such as Social Security payments, food stamps, or grants to needycollege students. Transfers can be treated as negative taxes.Government spending affects the model in exactly the same way as investment spending does, but theaddition of taxes forces some changes in the way we have been presenting the model. Simplyrelabeling the table above shows the effect of adding government spending. The column titled"Investment" could be called "Investment Plus Government Spending." The column titled "ActualIncome" would remain the same, but it would now be computed by adding together consumptionspending, investment spending, and government spending. Because government spending enters themodel in exactly the same way as investment spending, changes in it have the same multiplier effectsas do changes in investment spending.

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