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Expenditure Multiplier

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Expenditure Multiplier

Have you ever wondered what effect your spending money has on the economy? How does your spending impact the nation's GDP? What about government stimulus packages - how do they impact the economy? These are all very important questions that we can find answers to by learning all about the expenditure multiplier and how to calculate it. If this sounds interesting to you, stick around, and let's dive in!

Expenditure Multiplier Definition

The expenditure multiplier, also known as the spending multiplier, is a ratio that measures the total change in real GDP compared to the size of an autonomous change in aggregate spending. It measures the impact of each dollar spent during an initial rise in spending on a nation's total real GDP. The total change in real GDP is caused by an autonomous change in aggregate spending.

To understand the expenditure multiplier, we need to know what an autonomous change is and what aggregate spending is. The change is autonomous because it is self-governing, which means it "just happens." Aggregate spending is the total value of a nation's spending on final goods and services. Therefore, an autonomous change in aggregate spending is the initial change in total spending that causes a series of changes in income and spending.

The expenditure multiplier (spending multiplier) is a ratio that compares the total change in a nation's GDP caused by an autonomous change in aggregate spending to the amount of that change in spending. It measures the impact of each dollar spent during an initial rise in spending on a nation's total real GDP.

An autonomous change in aggregate spending is the initial change in total spending that causes a series of changes in income and spending.

The expenditure multiplier helps estimate the impact an increase in spending will have on the economy. To calculate the expenditure multiplier, we need to know how likely people are to save or consume (spend) their disposable income. This is a person's marginal propensity to save or their marginal propensity to consume. In this case, marginal refers to each additional dollar of income, and propensity refers to the likelihood that we will spend or save this dollar.

The marginal propensity to consume (MPC) is the increase in consumer spending when disposable income increases by a dollar.

The marginal propensity to save (MPS) is the increase in consumer saving when disposable income increases by a dollar.

Aggregate Expenditure

Aggregate expenditure or aggregate spending, also known as GDP, is the total spending of household consumption, government spending, investment spending, and net exports added together. It is how we calculate a nation's total spending on domestically produced final goods and services.

,

AE is aggregate expenditure;

C is household consumption;

I is investment spending;

G is government spending;

X is exports;

M is imports.

The expenditure multiplier measures the change in total real GDP that results from an initial change in one of the values above, except for imports and exports. Then, throughout the rounds of spending, there are additional changes in aggregate expenditure that occur as a chain reaction to the first round.

Expenditure Multiplier Equation

The expenditure multiplier equation requires us to take a few other steps before we calculate the expenditure multiplier. First, we will make four assumptions to help us understand the expenditure multiplier. Then we will calculate the MPC and MPS because either one is a required part of the expenditure multiplier formula.

Assumptions of the Expenditure Multiplier

The four assumptions that we make when calculating the expenditure multiplier are:

  • The price of goods is fixed. Producers are willing to supply additional goods if consumer spending increases without increasing the price of those goods.
  • The interest rate is fixed.
  • Government spending and taxes are zero.
  • Imports and exports are zero.

These assumptions are made to simplify the expenditure multiplier that we have to make an exception when considering the government expenditure multiplier.

MPC and MPS formula

If a consumer's disposable income increases, it can be expected that they will spend a portion of this additional income and save a portion. Since consumers typically do not spend or save all of their disposable income, the MPC and MPS will always be a value between 0 and 1 if we assume that consumer spending does not exceed disposable income.

To determine the marginal propensity to consume, we use this formula:

If consumer spending increases from $200 to $265 and disposable income increases from $425 to $550, what is the MPC?

So what happens to the portion of disposable income that is not spent? It goes into savings. Whatever additional income is not spent will be saved, therefore the MPS is:

Alternatively,

Let's say disposable income increased by $125, and consumer spending increased by $100. What is the MPS? What is the MPC?

Calculating Expenditure Multiplier

Now we are finally ready to calculate the expenditure multiplier. Our money goes through several rounds of spending, where each round sees some of it going to savings. With each round of spending, the amount injected back into the economy diminishes and eventually becomes zero. To avoid adding up each and every round of spending to figure out the total increase of real GDP caused by an autonomous change in aggregate spending, we use the expenditure multiplier formula:

If the MPC is equal to 0.4, what is the expenditure multiplier?

The expenditure multiplier is 1.667.

Did you notice the denominator in the equation for the expenditure multiplier? It is the same as the formula for the MPS. This means that the equation for the expenditure multiplier can also be written as:

The expenditure multiplier compares a nation's total change in real GDP after an autonomous change in aggregate spending to the size of that autonomous change in spending. This indicates that if we divide the total change in real GDP (ΔY) by the autonomous change in aggregate spending (ΔAAS), it is equal to the expenditure multiplier.

Expenditure Multiplier Example

If we take a look at an example of the expenditure multiplier, it will make more sense. The expenditure multiplier calculates how much real GDP increases after the economy experiences an autonomous change in aggregate spending. An autonomous change is a change that is the cause of the initial increase or decrease in spending. It is not the result. It could be something like a change in the tastes and preferences of society or a natural disaster that requires changes in spending.

For this example, we will say that after a particularly hot summer the year before, homeowners and builders decide to install pools in their yards for the next summer. This results in a $320 million increase in spending on pool construction. This $320 million is used to pay laborers, buy concrete, contract heavy machinery to dig the pools, purchase chemicals to prepare the water, update the surrounding landscaping, etc.

By paying the laborers, buying materials, and such, the first round of spending has increased disposable income (of those who are on the receiving end) by $320 million. Consumer spending has increased by $240 million.

First, calculate the MPC:

The MPC is 0.75.

Next, calculate the expenditure multiplier:

The expenditure multiplier is 4.

Now that we have the expenditure multiplier, we can finally calculate the impact on total real GDP. If the initial increase in spending is $320 million, and the MPC is 0.75, we know that with every round of spending, 75 cents of every dollar spent will go back into the economy, and 25 cents will be saved. To find the total increase in real GDP, we add up the increases in GDP after every round. Here is a visual representation:

Effect on real GDP$320 million increase in spending on pool construction, MPC=0.75
First round of spendingInitial increase in expenditure= $320 million
Second round of spendingMPC x $320 million
Third round of spendingMPC2 x $320 million
Fourth round of spendingMPC3 x $320 million
"
"
"
"
Total increase in real GDP

Table 1. Expenditure multiplier, StudySmarter Originals

Adding all of those values together would take a long time. Fortunately, since it is an arithmetic series and we know how to calculate the expenditure multiplier using the MPC, we do not have to add everything up individually. Instead, we can use this formula:

Now we insert our values:

The total increase in real GDP is $1,280 million or $1.28 billion.

Expenditure Multiplier Effects

The effect of the expenditure multiplier is an increase in a nation's real GDP. This happens because the nation experiences a rise in consumer spending. The expenditure multiplier has a positive effect on the economy because it means that a small increase in spending causes a larger increase in total real GDP. The expenditure multiplier also means that a small increase in spending can make a big difference in terms of people's disposable income.

How the expenditure multiplier works

The expenditure multiplier works by increasing the effect of each additional dollar spent in the economy every time it is spent. If there is an autonomous change in aggregate spending, people will earn more money in the form of increased wages and profits. They then go out and spend a portion of this new income on things like rent, groceries, or a trip to the mall. This translates as an increase in wages and profits for other people and businesses, who then spend another portion of this income and save the rest. The money will go through multiple rounds of spending until there is eventually nothing left of the original dollar that was spent. When all those rounds of spending are added together, we get the total increase in real GDP.

Types of Expenditure Multipliers

There are several types of expenditure multipliers, just like there are several types of spending. Different types of expenditure multipliers are government expenditure multiplier, consumer expenditure multiplier, and investment expenditure multiplier. Although they are all different types of expenditures, they are calculated mostly the same. The government expenditure multiplier makes an exception to the assumption that government spending and taxes are zero.

  • The government expenditure multiplier refers to the impact that government spending has on total real GDP.
  • The consumer expenditure multiplier refers to the impact that a change in consumer spending has on total real GDP.
  • The investment expenditure multiplier refers to the impact that a change in investment expenditure has on total real GDP.

Do not confuse these multipliers with the gross income multiplier (GIM), which is a formula in real estate used to determine the value of a property's sales price or rental value.

Type of expenditure multiplierFormula
Government expenditure Y is the real GDP;G is government spending.
Consumer expenditure
Investment expenditureI is investment spending.

Table 2. Types of expenditure multipliers, StudySmarter Originals

Did you enjoy learning about the expenditure multiplier? You can learn about multipliers in general or the tax multiplier from our explanations:

- Multipliers

- Tax Multiplier

Expenditure Multiplier - Key takeaways

  • An initial change in autonomous spending leads to further changes in total expenditures and total output.
  • The expenditure multiplier, also known as the spending multiplier, is a ratio that measures the total change in real GDP compared to the size of an autonomous change in aggregate spending. It measures the impact of each dollar spent during an initial rise in spending on a nation's total real GDP.
  • To calculate the expenditure multiplier, we need to know how likely people are to consume (spend) or save their disposable income. This is a person's marginal propensity to consume (MPC) or their marginal propensity to save (MPS).
  • The MPC is the change in consumer spending divided by the change in disposable income.
  • The MPC and the MPS add up to 1.

Frequently Asked Questions about Expenditure Multiplier

The expenditure multiplier (spending multiplier) is a ratio that compares the total change in a nation's GDP caused by an autonomous change in aggregate spending to the amount of change in spending. It measures the impact of each dollar spent during an initial rise in spending on a nation's total real GDP.

The government expenditure multiplier is calculated by finding the MPC by dividing the change in consumer spending by the change in disposable income. To calculate the government expenditure multiplier we divide 1 by (1-MPC). This equals the change in output over the change in gov. expenditure, which is the gov. expenditure multiplier.

The formula for the expenditure multiplier is 1 divided by 1-MPC.

Different types of expenditure multipliers are government expenditure, income expenditure, and investment expenditure.

Once you calculate the marginal propensity to consume (MPC), you insert it into the formula: 1/(1-MPC)

This will give you the expenditure multiplier.

Final Expenditure Multiplier Quiz

Question

What is the expenditure multiplier?

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Answer

The expenditure multiplier (spending multiplier) is a ratio that compares the total change in a nation's GDP caused by an autonomous change in aggregate spending to the amount of change in spending. It measures the impact of each dollar spent during an initial rise in spending on a nation's total real GDP.

Show question

Question

What is another term for the expenditure multiplier? 

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Answer

The spending multiplier.

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Question

What are the three types of expenditure multipliers?

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Answer

The government expenditure multiplier, the income-expenditure multiplier, and the investment expenditure multiplier.

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Question

What are the four assumptions of the expenditure multiplier?

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Answer

  • The price of goods is fixed.
  • Interest rate is fixed.
  • Government spending and taxes are zero.
  • Exports and imports are zero.

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Question

If consumer spending increases by $24 million and disposable income rises by $20 million, what is the MPC?

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Answer

The change in consumer spending should not exceed the change in disposable income since the MPC is a value between 0 and 1. 

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Question

If the MPS is 0.5, what is the expenditure multiplier?

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Answer

The expenditure multiplier is 2.

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Question

How does the expenditure multiplier work?

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Answer

The expenditure multiplier works by multipling the effect of each additional dollar spent in the economy through several rounds of spending. As one consumer spends, the dollar becomes revenue for another business which in turn spends it on buying inventory or paying wages. Every time the same dollar is spent it increases real GDP. 

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Question

Give an example of an autonomous change in aggregate spending.

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Answer

Homeowners and builders deciding to spend money on building pools in their yards after a hot summer.

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Question

If consumer spending increases from $200 to $300 and disposable income increases from $450 to $600, what is the MPC?

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Answer

.667

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Question

Let's say disposable income increased by $250, and consumer spending increased by $200. What is the MPC? What is the MPS?


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Answer

.8;.2

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Question

Let's say disposable income increased by $500, and consumer spending increased by $400. What is the MPC? What is the MPS?

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Answer

.8;.2

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Question

If the MPC is equal to 0.6, what is the expenditure multiplier?


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Answer

2.5

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Question

If the MPC is equal to 0.2, what is the expenditure multiplier?

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Answer

1.25

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Question

If the MPS is equal to 0.5, what is the expenditure multiplier?



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Answer

2

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Question

If the MPS is equal to 0.75, what is the expenditure multiplier?


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Answer

1.33

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Question

If consumer spending increases by $300 million and disposable income increases by $600 million, what is the expenditure multiplier?

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Answer

2

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Question

Let's say the government wants to spend $600 million on infrastructure. If consumer spending increases by $100 million and disposable income increases by $400 million, what is the total change in GDP?

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Answer

$800 million

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Question

Let's say the government wants to spend $450 million on infrastructure. If consumer spending increases by $200 million and disposable income increases by $400 million, what is the total change in GDP?

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Answer

$900 million

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Question

True or False: MPS and MPC add up to 1

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Answer

True

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True or False: To solve for MPC, you must divide the change in disposable income by the change in spending.

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Answer

False

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True or False: The effect of the expenditure multiplier is an increase in a nation's real GDP. 

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Answer

True

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True or False: You can find the expenditure multiplier without the MPS and MPC.

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Answer

False

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True or False: There are four assumptions when calculating the expenditure multiplier.

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Answer

True

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Question

Explain MPC.

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Answer

The increase in consumer spending when disposable income increases by a dollar

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Question

Explain MPS

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Answer

The increase in consumer saving when disposable income increases by a dollar


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Question

Explain aggregate expenditure.

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Answer

The total spending of household consumption, government spending, investment spending, and net exports added together. 

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Question

True or False: The expenditure multiplier can also be found by 1/MPS.

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Answer

True

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Question

True or False: Expenditure multiplier is stronger than tax multiplier.

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Answer

True

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