The Multiplier Effect Essay Example

the investment accelerator. Because of the multiplier effect, a dollar of government purchases can generate more than a dollar of aggregate demand. The logic of the multiplier effect, however, is not restricted to changes in government purchases. Instead, it applies to any event that alters spending on any component of GDP consumption, investment, government purchases, or net exports. For example, suppose that a recession overseas reduces the demand for U. S. net exports by $10 billion.

This reduced spending on U. S. goods and services depresses U. S. national income, which reduces spending by U. S. consumers. If the marginal propensity to consume is 3/4 and the multiplier is 4, then the $10 billion fall in net exports means a $40 billion contraction in aggregate demand. As another example, suppose that a stock-market boom increases households’ wealth and stimulates their spending on goods and services by $20 billion. This extra consumer spending increases national income, which in turn generates even more consumer spending.

If the marginal propensity to consume is 3/4 and the multiplier is 4, then the initial impulse of $20 billion in consumer spending translates into an $80 billion increase in aggregate demand. The multiplier is an important concept in macroeconomics because it shows how the economy can amplify the impact of changes in spending. A small initial change in consumption, investment, government purchases, or net exports can end up having a large effect on aggregate demand and, therefore, the economy’s production of goods and services.