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According to Keynesian theory, a change in one of the components of Total Expenditures will<br />

lead to a multiplied change in Real GDP. The multiplier effect occurs because the initial change in<br />

Total Expenditures triggers a chain reaction. In Example 8, investment spending increases by<br />

$120 billion. This new production generates $120 billion in new income for the resource owners<br />

who produced the new physical capital. What will the recipients of this income do with $120 billion<br />

in new income? (For simplicity, we will ignore the effect of taxes.)<br />

With an MPC of .60, consumption will increase by $72 billion ($120 billion x .60). This new<br />

production generates $72 billion in new income for the resource owners who produced the new<br />

consumption goods. This will lead to another $43.2 billion ($72 billion x .60) in new consumption.<br />

This new production generates $43.2 billion in new income for the resource owners who<br />

produced the new consumption goods. This will lead to another $25.92 billion ($43.2 billion x .60)<br />

in new consumption. The chain reaction continues. We can compute the eventual change in Real<br />

GDP by using the following formula:<br />

Change in Real GDP = Initial change x Multiplier<br />

The Multiplier<br />

The size of the multiplier effect depends on a factor called the multiplier. The multiplier is<br />

computed using the following formula:<br />

Multiplier = 1 ÷ (1 – MPC)<br />

Example 9: In Example 8 above, the MPC was .60. Thus, the multiplier would be 2.5, as<br />

computed below:<br />

Multiplier = 1 ÷ (1 – MPC) = 1 ÷ (1 – .60) = 1 ÷ .40 = 2.5<br />

With a multiplier of 2.5, the Change in Real GDP resulting from a $120 billion increase in<br />

investment would be a $300 billion increase, as computed below:<br />

Change in Real GDP = Initial change x Multiplier = $120 billion x 2.5 = $300 billion<br />

The size of the multiplier depends on the MPC. The greater the MPC, the larger the multiplier.<br />

The larger the multiplier, the larger the eventual change in Real GDP.<br />

Example 10: Assume the same facts as Example 8, except that the MPC is .75. When<br />

investment spending increases by $120 billion, what is the change in Real GDP?<br />

Multiplier = 1 ÷ (1 – MPC) = 1 ÷ (1 – .75) = 1 ÷ .25 = 4<br />

Change in Real GDP = Initial change x Multiplier = $120 billion x 4 = $480 billion<br />

In Examples 9 and 10, the initial change was an increase in Total Expenditures. What if the initial<br />

change is a decrease in Total Expenditures? According to Keynesian theory, the multiplier effect<br />

works the same for an initial decrease in Total Expenditures as for an initial increase. The initial<br />

decrease in Total Expenditures would lead to a multiplied decrease in Real GDP.<br />

Example 11: If investment spending decreases by $100 billion when the MPC is .80, what is the<br />

change in Real GDP?<br />

Multiplier = 1 ÷ (1 – MPC) = 1 ÷ (1 – .80) = 1 ÷ .20 = 5<br />

Change in Real GDP = Initial change x Multiplier = $100 billion decrease x 5 = $500 billion<br />

decrease<br />

FOR REVIEW ONLY - NOT FOR DISTRIBUTION<br />

8 - 9 Keynesian Economic Theory

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