Page 129 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes Multiplier Process

Suppose I rises. It means purchase of capital goods, etc. rises. This leads to rise in income of those
from whom these goods are purchased. When income rises, people spend a proportion of this
income (equal to MPC) on consumption. C rises. With rise in C, producers find their inventories
falling. They produce more output, and purchase more inputs. Income of the input sellers rises.
In this way with rise in income, cycle starts all over again.

! I Y C inventories output income
Caution
The cycle starting all over again does not mean that multiplier process goes on forever. It is
because only a fraction of income is consumed in each round until equilibrium of national
income is restored.
Size of the Multiplier

The size of multiplier depends upon MPC. A large MPC means a large increase in consumption
spending, a large increase in income and, therefore, a large multiplier. The process of increase in
income initiated by the change in investment reaches new equilibrium when change in
investment becomes equal to change in saving. We can show that:
1 1
Multiplier = =
MPS 1– MPC
S
Given MPS =
Y
At new equilibrium since S I, therefore,

ΔI
MPS =
ΔY
I 1
Or Y I
MPS MPS
It means that the change in income ( Y) is I times 1/MPS,

1 1
Multiplier
MPS 1–MPC
Algebraic derivation
Given C = a + bY .......... (i) Consumption function
Y = C+ I .......... (ii) Equilibrium
Substituting (i) in (ii), we get
Y = a + bY + I
Y–bY = a + I
Y (1–b) = a + I

1
Y = (a + I) ( )
1– b

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