How does Multiplier effect the relationship between changes in spending and changes in real GDP?


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Rosie Normanton answered
The multiplier effect causes the relationship between changes in spending and real Gross Domestic Product to strengthen. As people spend more, GDP rises (as consumption is a major component of GDP). The rise in GDP causes an increase in real incomes, as businesses thrive and more jobs become available. As individuals have higher incomes, their disposable income also rises, causing them to spend more. Hence there is a multiplier effect.

Of course, the relationship can work the other way too. If spending falls, so will real GDP. This will cause incomes to fall as people lose their jobs and consumer confidence decreases. Consumers will spend less because of the fall in real GDP; there is a negative multiplier effect.

  • The marginal propensity to consume

The size of a multiplier effect depends upon the average marginal propensity to consume of the citizens in an economy. The marginal propensity to consume indicates the strength of the multiplier effect; if it is high, the multiplier effect will appear more pronounced. It takes into account how the spending habits of citizens change as their incomes change.

The marginal propensity to consume will be high if an increase in income causes a proportionally large increase in spending. If citizens are more incentivized to save rather than spend, there will be a smaller multiplier effect. The marginal propensity to consume can be calculated by dividing change in income by change in consumption and multiplying by one hundred.

As it is, most citizens in developed countries have a large marginal propensity to consume. As their incomes rise, they like to spend more, possibly due to the large amount of goods and services available. Of course, the marginal propensity to consume is largely effected by confidence. People will save rather than spend in times of economic downturn, which can produce adverse effects in a recovery.

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