Government Purchases and the Multiplier Effect: Study with Video Lessons, Practice Problems & Examples

The multiplier effect illustrates how an initial change in government spending can lead to a larger overall increase in GDP. For instance, if the government spends $5 billion and households have a marginal propensity to consume (MPC) of 0.75, the total change in GDP can be calculated using the equation $1/1-\mathrm{MPC}$, resulting in a multiplier of 4. Thus, the total GDP increase would be $20 billion, demonstrating the significant impact of fiscal policy on aggregate demand.

Government Purchases GDP Multiplier

Now, let's see how the multiplier effect comes into play when we have a change in government spending. So we're dealing with fiscal policy and the multiplier effect describes this chain reaction. First, there's going to be an initial boost in government spending, which leads to a much higher increase in GDP. Now it can go the other way too. A decrease in government spending can lead to a much higher decrease in GDP for the same reason, this multiplier effect. Okay? Now I want to make a note. You've probably heard of the multiplier effect before and if you haven't, that's okay. The multiplier effect affects all the parts of GDP. So remember, GDP we have C+I+NX. Well, any of these three, a change in investment, government spending, or net exports, it's going to have a multiplier effect on consumption. Okay? That's how this multiplier effect works. It affects consumption in multiples. Most of the time when you talk about the multiplier effect, it's dealing with either an increase in investment spending or an increase in government spending, like we're going to discuss here. So let's go ahead and kind of play it out. Let's see how it works. First, the government is going to increase their spending, which in turn increases the income of households. How does that happen? Well, the government say they start a new construction project. They decide to refurbish the highways and bridges of the country. Well, they're going to need to hire people, right? They're going to hire construction workers to fix the highways and that's more income going to households, right? They're creating jobs that's increasing income. So when these in these households have increased income, well, guess what? It's going to lead to higher household consumption. When they're making more money, they're going to spend a little more on consumption. And you can refer to the marginal propensity to consume. We talk about that in another video. That's the idea for every more income. When you have more income, you're going to save some and spend some. Consume more, I'll say consume some, save some. So the marginal propensity to consume deals with how much of that extra income goes towards consumption, okay? So, after, that increased consumption, well, that increased consumption is going to create another wave of consumption and there's going to be even more consumption based on that additional consumption. So more and more consumption and it's going to keep going based on that marginal propensity to consume. So let's imagine this example here. Government land has increased government spending by $5,000,000,000 So this initial $5,000,000,000 well, it's going to increase consumer spending. So let's imagine that those $5,000,000,000 that the government spent was all earned by households, okay? And let's say that households have a marginal propensity to consume of 0.75. So that means for every dollar that they earn, they're going to spend $0.75 of that dollar, okay? So let's get out of calculator and let's make this assumption right here. So, let's say the marginal propensity to consume is 75, that means this $5,000,000,000 of extra spending, 75% of it is going to be spent in the second round right here. So that means of the $5,000,000,000 the government spent, well, households earned $5,000,000,000 And then those households went out and spent $3,750,000,000 because of that. They saved the other portion of it, but they spent $3,750,000,000 and that $3,750,000,000 that was spent, well, it was earned by somebody and they're going to spend 75% of it. Right? So you can imagine that this 3.75 is now going to go through another round of multiplier effect here. And it's about $2,800,000,000 in the next round. So times 0.75 again is about $2,100,000,000 in the next round, and this keeps happening. Notice it keeps getting smaller, But this all in sum leads to a lot more, spending than just the initial $5,000,000,000 dollars right? There was initially $5,000,000,000 spent by the government, but it led to this chain reaction of extra spending based on people earning money and spending it and earning money and spending it, right? So this initial boost in spending has this multiplier effect. So how does this affect aggregate demand? Well, remember here, I'm going to move this over here. So right here, we had a chain government purchases increasing, and then consumption increasing, consumption increasing, consumption increasing, right? These are all parts of our GDP equation, parts of our aggregate demand. So as this happens, what we see on our aggregate demand graph is remember, this is price level and this is GDP over here. So if we were initially, at this point, well, we would first have one shift to the right from the government spending. So we'll say, from g, right? That first initial spending and then it's going to boost again, maybe a little smaller boost. And this will be from the first round of consumption and then another boost, maybe even smaller. And this is c2. Right? It keeps boosting to the right based on this additional spending. Right? So the multiplier effect really tells us that we don't just get this one boost from government purchases. There's multiple boosts going on here, right? It's not just the one boost to the aggregate demand. There's additional shifts that happen from this multiplier effect. So when it all rounds out, what actually happens with the multiplayer effect? Well, this is our equation right here. Remember that multiplier was all based on that marginal propensity to consume. When the consumers when the households got this extra money based on the government spending, well, they didn't spend all of it. So depending on how much of it they're willing to spend is how big the multiplier is going to be. You can imagine the more that the households are willing to spend, there's going to be a bigger multiplier effect because there's more and more spending going on. So this right here is how we calculate our multiplier. 1/1−MPC is the multiplier. Okay? So sometimes on a test, they'll just ask you what is the multiplier in this situation? And for our situation, we'd go 1/0.25 which is 4. So in our case, the multiplier was 4, meaning the initial spending of the government the initial spending, the government spent 5. Well, the total change in GDP would be 5 times 4, right? Our multiplier right there, which is 20. So when the marginal propensity to consume that MPC is 0.75, Well, an initial change of spending of 5 by the government actually affects the GDP by an increase of 20, Okay? So that's quite a big increase. So you can see that fiscal policy can have a multiplier effect in the sense that maybe just by increasing spending a little, there can be a great change in the economy. Okay? So there we go. That's the multiplier effect. Be familiar with this equation, 1/1−MPC. They love to test on that. Alright? Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What is the multiplier effect in macroeconomics?

The multiplier effect in macroeconomics refers to the phenomenon where an initial change in spending (such as government spending) leads to a larger overall increase in GDP. This occurs because the initial spending creates income for households, which then spend a portion of this income, creating further income and spending in subsequent rounds. The size of the multiplier effect depends on the marginal propensity to consume (MPC). The formula to calculate the multiplier is $\frac{1}{1-\mathrm{MPC}}$. For example, if the MPC is 0.75, the multiplier is 4, meaning an initial $5 billion increase in spending could ultimately increase GDP by $20 billion.

How does government spending affect aggregate demand?

Government spending affects aggregate demand by directly increasing the total amount of spending in the economy. When the government spends money, for example on infrastructure projects, it creates jobs and income for households. These households then spend a portion of their increased income, further boosting consumption. This chain reaction, known as the multiplier effect, leads to multiple rounds of increased spending, shifting the aggregate demand curve to the right. The overall impact on aggregate demand depends on the size of the multiplier, which is determined by the marginal propensity to consume (MPC).

How do you calculate the multiplier in macroeconomics?

The multiplier in macroeconomics is calculated using the formula $\frac{1}{1-\mathrm{MPC}}$, where MPC stands for the marginal propensity to consume. This formula shows how much total GDP will change in response to an initial change in spending. For example, if the MPC is 0.75, the multiplier is $\frac{1}{1-0.75}$ = 4. This means that an initial $1 billion increase in government spending would ultimately increase GDP by $4 billion.

What is the relationship between the marginal propensity to consume (MPC) and the multiplier effect?

The marginal propensity to consume (MPC) is directly related to the multiplier effect. The MPC measures the proportion of additional income that households will spend rather than save. The higher the MPC, the larger the multiplier effect, because more of each dollar of income is spent, leading to more rounds of spending. The multiplier is calculated using the formula $\frac{1}{1-\mathrm{MPC}}$. For example, if the MPC is 0.75, the multiplier is 4, meaning an initial increase in spending will have a fourfold impact on GDP.

Can the multiplier effect work in reverse with a decrease in government spending?

Yes, the multiplier effect can work in reverse with a decrease in government spending. When the government reduces its spending, it leads to a decrease in income for households, which then spend less. This reduction in spending causes further decreases in income and spending in subsequent rounds, leading to a larger overall decrease in GDP. The size of the negative multiplier effect also depends on the marginal propensity to consume (MPC). For example, if the MPC is 0.75, a $1 billion decrease in government spending could ultimately reduce GDP by $4 billion.