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Macroeconomics: multiplier and crowding out effects

Multiplier effect: whenever any of the components of AD increases, the increase in GDP will be greater than the initial increase in expenditures.

  • The impact on GDP of a particular increase in spending depends on the proportion of the new income that is taken out of the system to the proportion that continues to circulate in the economy.
  • The multiplier effect tells us the impact a particular change in one the components of AD will have on the total income (GDP).  Let k denote the spending multiplier, which is a function of MPC and MPS.

  • The larger the marginal propensity to consume, the larger the spending multiplier. Notice that the larger the MPC, the greater the impact a particular change in the spending variables will have on the nation's GDP.
The crowding out effect: If government spending increases without an increase in taxes, the government must borrow funds from the private sector to finance its deficit, thereby increasing the interest rate.

  • This increase in interest rate, driven by government spending, decreases the quantity of private investment demand.
  • The term crowding out refers to the drop in private investment demand caused by a government's deficit financed expansionary fiscal policy.
  • As you can see after once the government enters the market, the quantity demanded by private borrowers is much smaller than before (QP2<QP1). Therefore, when the government borrows money,  the variable G increases while the variable I decreases. However both variables do not have to change by the same amount.

  • Both effects are used as argument in favor or against the use of expansionary policies during economic contractions.
  • The multiplier effect says that an increase in government spending during a recession can have an important impact on the level of AD and national output. Pushing the economy toward full employment level of output.
  • The crowding out effect supports the idea that an increase in government spending and a decrease in taxes during a recession will have a weaker impact on AD, since the increase in G will be partially offset by a drop in I.

Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 118-121.

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