Question

‘The size of multiplier varies directly with the size of MPC.’ Discuss.

Show how the size of the multiplier varies with the size of the marginal propensity to consume.

Answer 1

The multiplier and the marginal propensity to consume (MPC) have a direct relationship: as the MPC increases, the multiplier also increases. This is because a higher MPC means that a larger portion of each additional dollar of income is spent on new goods and services, leading to a greater chain reaction of economic activity. The relationship is expressed by the formula:

Multiplier (K) = `1/(1 - "MPC")`

1. Higher MPC = More Spending: If people have a high MPC, they spend a large fraction of their extra income.
2. Chain Reaction: This spending goes to other businesses, which then have more income. They, in turn, spend a portion of that new income, continuing the cycle.
3. Greater Impact: Because each round of spending is a larger proportion of the previous income, the total impact on the economy is magnified, resulting in a larger multiplier.

Examples:

High MPC: If MPC = 0.8.

Multiplier = `1/(1 - 0.8)`

= `1/0.2`

= 5

Lower MPC: If MPC = 0.5.

Multiplier = `1/(1 - 0.5)`

= `1/0.5`

= 2