Explain the operation of the Keynesian multiplier

University Degree Business and Administrative studies

Explain the operation of the Keynesian multiplier

(A)

The Keynesian multiplier shows the change is output when there is a change in investment. The basic model Keynes offered consists of an economy with only consumption (C) and investment (I), which add together to give national income or output (Y). Thus, a simple equation can be given:

Y=C+I.

The aggregate consumption function is the level of aggregate consumption that is desired at each level of personal disposable income (personal disposable income is the income households have available for spending or saving, after transfer payments from and taxation payments to the government have been accounted for). The consumption function in this simple model therefore represents desired consumption at different levels of national income. The marginal propensity to consumer (MPC) is the fraction of each extra unit of disposable income which households will consume. For instance, it may the case that 80% of disposable income is spent, which means that the remaining 20% is saved. The MPC is represented in the consumption function as A. B is the minimum amount of consumption that is spent for survival – it is assumed that even when no income is being produced, households will still need to spend their money on necessities to survive, for which they will break into savings.

The consumption function is C=A+bY, which is the marginal propensity to consume.

This is drawn in figure one[1]. Because C+I equals Y, a 45° degree line is drawn in, showing all the points where this is true. Equilibrium occurs at the point where the MPC line crosses the 45° line.

The formula for the multiplier is 1/(1-MPC). This can be simplified to 1/MPS, where MPS is the marginal propensity to save. In our earlier example, MPC=A=0.7 , which meant that 70% of income was consumed. Therefore, MPS must be 1-MPC=0.3.

Thus, when MPC=0.7, the multiplier is:

1/MPS=1/0.3=3.3

This means ...