Economics Chapter 2: Keynesian Multiplier Model

The Keynesian Multiplier Model

• The model explores how the equilibrium level of national income is determined in the short-run in a closed economy with fixed wages and prices.
• The model is called the multiplier model because a dollar spent in the economy leads to more than a dollar change in real GDP.

Consumption Function (CC)

• Each point on CC represents the planned or desired consumption at each level of disposable income.

Saving Function (SS)

• Each point on SS represents the planned or desired saving at each level of disposable income.
• SS is the mirror image of CC, and what affects CC will affect SS but in the opposite direction.

Investment Function (II)

• Investment is determined by factors like interest rate, expectations, and taxes, making it autonomous (independent of the level of disposable income).
• II curve is horizontal, indicating that it is constant regardless of the level of output.

Investment-Saving Graph

• The graph shows the equilibrium point E where planned saving equals planned investment.

The Expenditure Approach of Determining Output

• The total desired spending by households and firms is represented by (I + C).
• The (C + I) curve represents the total desired spending, which intersects with the 45° line to determine the equilibrium level of output.

Real GDP and Aggregate Demand

• Real GDP is an indicator of the economy's progress and is determined by potential output in the long-run and aggregate demand in the short-run.
• Any change in spending will have an impact on GDP and employment through the multiplier effect.

The Multiplier

• The multiplier is the amount by which an initial change in expenditure is multiplied to find the change in income (output).
• The formula for the multiplier is: Multiplier = 1 / (1 - MPC) = 1 / MPS

Example of the Multiplier

• If firms invest $100 million, and the marginal propensity to consume (MPC) is 0.8, the initial investment will lead to an additional income of $500 million.
• The multiplier effect continues as individuals spend 80% of their income, and so on.

The Size of the Multiplier

• The size of the multiplier depends on the consumption pattern, with a larger MPC leading to a larger effect on income.
• The formula for the change in output is: Change in output = [1 / (1 – MPC)] X change in investment.

The Downward Effect of the Multiplier

• If autonomous investment decreases rather than increases, the multiplier effect will also work downwards, leading to a decrease in GDP.