"A key concept in Keynesian economics is the expenditure multiplier. The expenditure multiplier is the idea that not only does spending affect the equilibrium level of GDP, but that spending is powerful. More precisely, it means that a change in spending causes a more than proportionate change in GDP. The reason for the expenditure multiplier is that one person's spending becomes another person's income, which leads to additional spending and additional income so that the cumulative impact on GDP is larger than the initial increase in spending." For example, if you go to a store and spend $50, the store owner gets the money in exchange for some goods that you purchased. What do you think would happen to your $50? The store owner will spend, say 75% ($50x.75=$37.5) to pay for gas. The gas station will pay 75% for groceries ($37.5x.75=$28.1) and so on. By the time the process gets completed, your original $50 would have impacted the economy by more than the initial $50.

1. Simple Multiplier= 1/1-mpc Consumption= autonomous consumption + marginal propensity to consume(income)= Ca+mpc(Y)

Assume, Y= income; Ca=b then we can write Y=ca+b(y)=Y-b(Y)= ca= Y(1-b)=ca= Y= ca/1-b or ca/1-mpc

Marginal propensity to consume (MPC)= change in consumption/change in income Marginal propensity to save (MPS)= change in saving/change in income 1= MPC+MPS Therefore, MPC=1-MPS

Therefore MPS= 1-MPC So, 1/1-MPC= 1/MPS If MPC is 75 cents for every dollar of income, then 1/1-.75= 1/.25= 4 (this means that each dollar of consumption (C), investment (I), government(G) and net export(NX) will affect the economy 4 times:

2. Expenditure Multiplier= 1/1-mpc (C+I+G+NX)= C+I+G+NX/1-MPC If the economy is at $600 billion and the potential GDP is at $800 billion, then the recessionary gap is $200 billion. How much government spending should be made to close the gap if MPC=.75

1/1-.75 x $50 billion= 1/.25 x $50 billion= $200 billion [ How did I get the $50 billion? once we know what the gap is between the economy's equilibrium ($600b) and potential GDP ($800b), then we multiply the gap by the multiplier [$200 x 1/.25= $200/.25=$200/4=$50 billion]

The expenditure multiplier works in reverse. That is, if we have $200 inflationary gap, at a multiplier of 4, the economy will contract by 4 x -$50 billion equals -$200 billion because govt spending supposed to be reduced.

Typical question: Assume Y= Ca + b(Y-T)= Y= 20+ .5(Y-T)+I+GWhere: T=taxes= $40; I= $60; G= $80 What is Y?

To solve this, you should solve for Y as we did above to get the answer.

3. Tax Multiplier (i) Expansionary fiscal policy

1/1-MPC x MPC= MPC/1-MPC or MPC/MPS (effect of reducing taxes)

(ii) Contractionary fiscal policy

1/1-MPC x -MPC= -MPC/1-MPC or -MPC/MPS

If the economy is at $600 billion and the potential GDP is at $810 billion, then the recessionary gap is $210 billion. How much government spending should be made to close the gap if the MPC=.75.

1/1-.75 x .75= .75/.25= 3 (this means that each dollar of tax reduction will affect the economy 3 times).

1/1-.75 x .75 x $70 billion= .75/.25x$70 billion= $210 billion [ How did I get the $70 billion? Once we know what the gap is then we divide the number by the multiplier= $210/3= $70 billion]