Definition
Keynesian Multiplier
The Keynesian multiplier is the proportional increase in real GDP that results from an initial injection into the economy.
- Imagine that an initial increase in C, I, G or (X-M), lead to an increase in Aggregate Demand, and hence an increase in real output (GDP).
- Even though it is easy to assume that the increase in real output will be proportional to the increase in the initial injection, in reality, the total increase in real output will be higher (The reasoning is discussed further below).
- The reason behind this is the Keynesian Multiplier, which is calculated by:
- $\text{Multiplier} =\frac{\text{Change in Real GDP}}{\text{Initial Change in Expenditure}}$
- $\text{Change in Real GDP} = \text{Multiplier} \times \text{Initial Change in Expenditure}$
Imagine the government spends $100 million on building a new highway.
- This money goes to construction workers, suppliers, and other businesses.
- These recipients then spend a portion of their income on goods and services, which becomes income for others.
- This cycle continues, generating induced spending.
- Therefore, the total increase in GDP is greater than the initial $100 million.
Marginal Propensities
- The Keynesian multiplier is influenced by the consumer spending, in specifics, the marginal propensities in the economy. We can use these marginal propensities to calculate the multiplier as well.
- Marginal Propensities are the tendencies for consumers to allocate additional income for a certain purpose.
- Marginal Propensity to Consume (MPC): The fraction of additional income that is spent on consumption.
- Marginal Propensity to Save (MPS): The fraction of additional income that is saved.
- Marginal Propensity to Tax (MPT): The fraction of additional income that is paid in taxes.
- Marginal Propensity to Import (MPM): The fraction of additional income that is spent on imports.
- The propensities are all related such that: $\text{MPC}+\text{MPS}+\text{MPT}+\text{MPM}=1$
The sum of these propensities equals 1 because the additional income is either spent, saved, taxed, or used for imports.
Calculating the Keynesian Multiplier
- Therefore, the Keynesian multiplier can be calculated using these formulas:
- $\text{Multiplier} = \frac{1}{\text{MPC}}$
- $\text{Multiplier}= \frac{1}{(\text{MPS}+\text{MPT}+\text{MPM})}$
Remember:
- The greater the MPC, the greater the multiplier.
- The greater the savings, taxes, and imports, the smaller the multiplier.
The larger the multiplier, the greater the impact of the initial injection on real GDP.
The Effects of Multiplier on Aggregate Demand
Discussed before, the total change in real output will be higher than the initial investments.
