Example of question

Explain how a change in investment can affect the multiplier. Make use of a practical example and
use formula(s) where necessary.”

Answer
Refer to page 372 of the textbook to see the figure and how the process is illustrated.

Suppose investment increases by R 50 million. This shifts the aggregate spending. The increased
investment increases income through new wages, salaries and profits.

The new wages and salaries are spent on goods and services, and some of these wages and salaries is
saved by these consumers in the economy. This is determined by the marginal propensity to consume
and marginal propensity to save. Once the salaries and wages are spent, they generate income for
shopkeepers and firms. Shopkeepers also spend some of the income and save the rest of their income,
just like consumers. However, their spending and saving is smaller than the initial wages and salaries.
This process continues and gets progressively smaller, until a new equilibrium is reached where
spending is equal to income.

The multiplier effect refers to the fact that there is a greater increase in total income than the
initial increase in investment.

The size of the multiplier is determined by c and is equal to α=1/(1-c). The change in income is equal
to ΔY=αΔA.