Spending Multiplier
Total impact of spending given marginal consumption.
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Example
Spending ripples through economy
How it works
The spending multiplier tells you how much total income or output changes after an initial change in spending, once repeated rounds of re-spending are counted. If people spend a fraction MPC of any extra income they receive, then each new round of spending is smaller than the last, creating a geometric series whose sum is 1 / (1 - MPC). The formula works in the simple Keynesian model because one person's spending becomes another person's income, which then induces further consumption.
When to use it
Use this when analyzing how changes in government spending, investment, exports, or other autonomous spending affect total GDP in a short-run macroeconomic model. It is especially useful when prices are sticky and you want to estimate the amplified effect of an initial demand shock.
Worked example, step by step
Suppose the marginal propensity to consume is MPC = 0.8. Step 1: Write the multiplier formula: k = 1 / (1 - MPC) Step 2: Substitute the value: k = 1 / (1 - 0.8) Step 3: Simplify the denominator: k = 1 / 0.2 Step 4: Calculate: k = 5 Step 5: If government spending rises by $40 million, total income changes by 5 × $40 million = $200 million Final answer: the spending multiplier is 5, so a $40 million increase in spending raises total output by $200 million in this model.
Common mistakes to avoid
- Using APC instead of MPC, which measures average rather than marginal spending behavior
- Forgetting that the formula assumes a constant MPC and repeated rounds of spending
- Applying the multiplier in a context with strong price changes, leakages, or supply constraints without adjusting the model
Did You Know?
The spending multiplier means one dollar of government spending can ripple into several dollars of activity.
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