The Multiplier Model

Question 1

What are the 2 types of expenditure in the multiplier model?

Answer 1

1. Consumption
2. Investment

Question 2

How is consumption spending modeled in the multiplier model?

Answer 2

C = C0 + C1Y , where c0 is autonomous consumption and c1 is the marginal propensity to consume out of income

Question 3

What is autonomous consumption (c0) and what does it depend on?

Answer 3

Consumption independent of income coming from the desire to smooth consumption. It depends on expectations of future income, if a future income decrease is expected to be permanent autonomous consumption will decrease.

Question 4

What does the C1 component of consumption spending represent and what dos it depend on?

Answer 4

C1 = marginal propensity to consume out of income, the level of consumption that is based on income
Depends on households weakness-of-will and credit constraints. If either of these worsen, then the marginal propensity to consumer out of income will increase

Question 5

Describe the multiplier diagram?

Answer 5

y-axis = aggregate demand (AD)
x-axis = output/income (Y)
45 degree line where AD = Y
A line intersecting 45 degree with c0+c1Y+I

Question 6

Describe what happens when investment falls by £1.5bn using multiplier diagram?

Answer 6

Original line shifts downwards by£1.5bn when investment falls, the decrease in output is greater than the increase in AD (£1.5bn) due to the multiplier

Question 7

What is the multiplier equation when using consumption and investment spending?

Answer 7

1/(1-c1)

Question 8

What does the multiplier show?

Answer 8

How much GDP would change in response to an initial change in spending

Question 9

What 3 reasons caused autonomous spending to fall during the Great Depression?

Answer 9

1. Uncertainty
2. Pessimism about future income
3. Tightening of credit

Question 10

What do households do if target wealth is above expected wealth?

Answer 10

Decrease consumption and increase savings

Question 11

What do household do if target wealth is below expected wealth?

Answer 11

Decrease savings and increase consumption

Question 12

Explain the credit cycle for households?

Answer 12

Family A sells their house which lowers the price of houses, which lowers the value of other households’ collateral, reducing their ability to borrow, with lower ability to borrow other households reduce their demand for property purchases and consumption which continues the cycle

Question 13

What is the incentive for firms to invest?

Answer 13

Firms will have a greater incentive to invest if the investment projects earn a higher return than their opportunity cost - IF RATE OF RETURN TO NEW INVESTMENTS IS HIGH RELATIVE TO MARKET INTEREST RATES FIRMS WILL HAVE AN INCENTIVE TO INVEST

Question 14

What are 3 opportunity costs of investment?

Answer 14

1. Pay down debt
2. purchase financial securities
3. return funds to shareholders (pay dividends)

Question 15

What is the multiplier model equation when govt expenditure and net exports are included?

Answer 15

Y = c0 + c1(1-t)Y + I + G + X -mY
where t = income tax rate, m=marginal propensity to import

Question 16

What is the multiplier when govt exp and net exports are included?

Answer 16

1/ 1-c1(1-t) + m

Question 17

What is the relationship between the multiplier and the tax rate, and marginal propensity to import

Answer 17

Multiplier is decreasing in the tax rate, and deceasing in the marginal propensity to imports