100 ❯ Step 4. Review the Knowledge You Need to Score High
Round 1: Firms increase investment spending by $10, which acts as an injection of new
money into the economy.
Round 2: The $10 acts as income to resource suppliers (households) and with an MPC
= .80, households spend $8 and save $2.
Round 3: The $8 of new consumption spending (C) is income for other households, and
they spend 80 percent, or $6.40, and save $1.60.
Round 4: The $6.40 of new C is income for other households, and they spend 80 percent,
or $5.12, and save $1.28.
This process repeats. Each time the dollars circulate through the economy, 80 percent
is spent and 20 percent is saved. After four rounds, there has been $10 + $8 + $6.40 +
$5.12 = $29.52 of new GDP. The process continues until households are trying to consume
80 percent of virtually nothing and the increase in new GDP comes to an eventual stop.
This is called the multiplier effect. A change in any component of autonomous
spending creates a larger change in GDP. The discussion of the “rounds” of spending
above implies that the marginal propensities to consume and save play a critical role in
determining the magnitude of the multiplier. There are two equivalent ways to calculate
the multiplier if you know the MPC or MPS. The magnitude of the spending multiplier
is found by taking a ratio:
Multiplier = 1/(1 - MPC) = 1 /(1 - .80) = 5
Since MPC + MPS = 1,
Multiplier = 1 /MPS = 1/.20 = 5.
The spending multiplier can be found by using one of the following equations:• Multiplier = 1/MPS
• Multiplier = 1/(1-MPC)
• Multiplier = (D GDP)/(D Spending)Some common spending multipliers are as follows:• MPC = .90, Multiplier = 1/.10 = 10
• MPC = .80, Multiplier = 1/.20 = 5
• MPC = .75, Multiplier = 1/.25 = 4
• MPC = .50, Multiplier = 1/.50 = 2Public and Foreign Sectors
The inclusion of government spending (G) and net exports (X – M) act in the very same
way as the change in investment illustrated in the preceding example.Government Spending (G)
With the MPC =.80, we have found the spending multiplier equal to 5. If autonomous
government spending is incorporated into the circular flow model, the multiplier effect is
again felt throughout the economy. If G = $20, we could expect those $20 to multiply to
$100 in new GDP.Net Exports (X-M)
The final sector of the macroeconomy is the foreign sector. The addition or subtraction (if
imports exceed exports) of autonomous net exports is an increase (or decrease) of dollars inTIP