the multiplier effect and crowding out slides by john dawson and kevin brady begin interactive...
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The Multiplier Effect and Crowding Out
Slides By
John Dawson and Kevin Brady
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CoreEconomics, 2e
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Material from this presentation can be found in:
Chapter 18Chapter 20
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The Multiplier Effect and Crowding Out
Economists estimate the effect of additional spending, whether it is through consumption, investment, or government purchases, by calculating the size of the spending multiplier.
Question 1:
What is the formula for the spending multiplier?
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The Multiplier Effect and Crowding Out
Economists estimate the effect of additional spending on equilibrium income, whether the additional spending comes from consumption, investment, or government purchases, by calculating size of the spending multiplier.
Question 1:
What is the formula for the spending multiplier?
Answer to Question 1:
k = 1/(1-MPC)
k is the spending multiplier and MPC is the marginal propensity to consume.
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The Multiplier Effect and Crowding Out
Question 2:
If the marginal propensity to consume is 90%, what is the spending multiplier?
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The Multiplier Effect and Crowding Out
Question 2:
If the marginal propensity to consume is 90%, what is the spending multiplier?
Answer to Question 2:
Using the formula k = 1/(1-MPC), we find that the spending multiplier is 10.
k = 1/(1-.90)k = 1/.10k = 10
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The Multiplier Effect and Crowding Out
Question 3:
If the marginal propensity to save is 20%, what is the spending multiplier?
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The Multiplier Effect and Crowding Out
Question 3:
If the marginal propensity to save is 20%, what is the spending multiplier?
Answer to Question 3:
Recall that the marginal propensity to save (MPS) is equal to 1-MPC. Thus, applying the spendingmultiplier formula, we find the spending multiplier is 5.
k = 1/(1-MPC)k = 1/MPSk = 1/.20k = 5
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The Multiplier Effect and Crowding Out
Question 4:
Assume the current equilibrium income in the economy is $5,000,000. If the full employmentequilibrium income is $6,600,000, and the spending multiplier is 4, what amount of governmentspending would bring us to the full employment equilibrium?
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The Multiplier Effect and Crowding Out
Question 4:
Assume the current equilibrium income in the economy is $5,000,000. If the full employment equilibrium income is $6,600,000, and the spending multiplier is 4, what amount of government spending would bring us to the full employment equilibrium?
Answer to Question 4:
A spending multiplier of 4 implies that income will rise $4 for every $1 in spending. Since the economy needs an additional $1,600,000 in income to reach the full employment equilibrium, $400,000 in spending would be required.
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The Multiplier Effect and Crowding Out
Question 5:
Explain what causes the spending multiplier to be greater than one.
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The Multiplier Effect and Crowding Out
Question 5:
Explain what causes the spending multiplier to be greater than one.
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Answer to Question 5:
A spending multiplier greater than one occurs when increased government spending stimulatesmore private spending by consumers and businesses in the economy. For example, when thegovernment spends money on building or repairing roads and bridges, the workers who are hiredfor the job may increase their spending (thus increasing consumption) and the constructioncompany performing the work may buy new equipment for the job (thus increasing investment). The total increase in spending (and GDP) is therefore more than the initial increase in governmentspending.
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The Multiplier Effect and Crowding Out
Question 6:
What causes the crowding out effect?
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The Multiplier Effect and Crowding Out
Question 6:
What causes the crowding out effect?
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Answer to Question 6:
There are several possible sources of crowding out. First, higher government spending may befinanced by higher taxes which reduce private consumption spending. Second, higher governmentspending may be financed by borrowing (issuing government bonds) which reduces spending onprivate bonds, therefore decreasing private investment spending. Third, if government borrowingto finance increases in government spending reaches high enough levels, the issue of additionalbonds may depress bond prices and raise interest rates. Higher interest rates make consumer andbusiness spending more expensive, thus further decreasing private consumption and investment.
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