Question

a. (10 pts) Describe how the multiplier process works. b. (10 pts) Use a chart to show how 10 rounds of expenditure will increase real GDP. In particular, show the increase in the current round, and the cumulative increase from previous rounds.

Answer 1

a) It measures the change in national income due to change in investment level. When there in increase in investment, national income rises by multiple of it. Multiplier is calculated as Change in Income / Change in Investment.

Assume MPC = 0.8 and investment raised by 100 crores. It will directly raise the level of income by 100 crore as one person spending is another person income.

Round	Change in Investment	Increase in GDP	Cumulative Increase in GDP
1	100	100.00	100.00
2	-	80.00	180.00
3	-	64.00	244.00
4	-	51.20	295.20
5	-	40.96	336.16
6	-	32.77	368.93
7	-	26.21	395.14
8	-	20.97	416.11
9	-	16.78	432.89
10	-	13.42	446.31

Equation of consumption function is C = a + bY where a is intercept and b is slope of function or MPC.

Change in Y = Change in I + MPC * Change in I + MPC^2 * Change in I………………

Change in Y = Change in I (1 + MPC + MPC^2……)

Sum of geometric progression is:

Change in Y / Change in I = [1 / (1 – MPC)] where [1 / (1 - MPC) is the spending multiplier = [1 / (1 - 0.8)] = 5

As MPC = 0.8, investment of 100 crore will result in increase in GDP by 100 * 5 = 500 crore

b) In the diagram below, we can see that real GDP per round is falling while cumulative real GDP is rising.

Increase in GDP 500.00 450.00 400.00 350.00 300.00 250.00 200.00 150.00 100.00 50.00 0.00 100 1 2 3 4 5 6 7 8 9 10 Round Increase in GDP Cumulative Increase in GDP