Spending Multiplier
How much total output rises from an initial change in spending.
Formula
Variables
Example
MPC 0.8: k = 1/(1−0.8) = 5
How it works
The spending multiplier tells you how a one-time increase in spending can lead to a larger overall increase in national income or output. It works because when people receive extra income, they usually spend part of it and save the rest; that next round of spending becomes income for someone else, creating repeated rounds that shrink each time by the MPC. The formula sums this chain of spending into one multiplier, which is why a higher MPC produces a larger total effect.
When to use it
Use this when analyzing fiscal policy, such as government spending increases, tax cuts, or any injection into the circular flow of income. It is also useful when estimating the total impact of new demand on GDP in simple macroeconomic models.
Worked example, step by step
Suppose the marginal propensity to consume is 0.6. Step 1: Substitute into the formula: k = 1 / (1 - MPC) Step 2: k = 1 / (1 - 0.6) Step 3: k = 1 / 0.4 Step 4: k = 2.5 So, an initial increase in spending of $10 billion would raise total output by $25 billion in this simplified model.
Common mistakes to avoid
- Using MPC as the multiplier itself instead of putting it into 1/(1 - MPC)
- Forgetting that the formula gives the total final change in output, not just the first round of spending
- Applying the formula when the economy has capacity constraints, strong inflation, or other leakages not included in the simple model
Did You Know?
With an MPC of 0.8, $1 of new government spending can generate up to $5 of total economic activity.
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