Macroeconomics Assignment Week 9

1. Explain how the multiplier should work in theory. You need to use equations in your answer

Aggregate demand is equivalent to the national income, while also indicating the real GDP.
Aggregate demand (AD) comprises 4 components, the consumption of goods and services by
households (C), investment by private firms (I), government expenditure (G), and net exports (X-M).

C = co + c1(Y-T)
Consumption (C) is dependent on disposable income which is income after tax is paid. It comprises
of autonomous expenditure (C0) and the proportion of changes in disposable income for
consumption C1(Y-T).

Y=
( 1−c 1 +m)(
C 0 + I0
−
b
1−c 1 +m ) (
r+
1
1−c 1 +m
G−
) (
c1
1−c 1+ m
T+
mF
) (
1−c1 +m
YF
)
 C1 is the marginal propensity to consume (MPC)
 (1-C1) is the marginal propensity to save (MPS)
 m is the marginal propensity to import (MPM)

Based on the formula above, this is the multiplier formula which is defined as the change of real GDP
from the given change of one component of aggregate expenditure. MPC is the change in
consumption when disposable income varies. MPS measures how much households save depending
on how much the level of income changes. Lastly, MPM measures the change in import levels when
a change in disposable income occurs.

In a circular flow model, the multiplier applies as a person’s spendings become another person’s
income. For example, if the government increases social welfare payments, the people employed in
building new public facilities will gain more income. Employees will purchase both necessities and
luxurious goods using their income. However, not all their income will be used to spend on goods. A
proportion will be spent on paying income tax and imports, while the rest will be saved as household
savings. Consumption of goods and services will provide other people’s income, who then spend on
consumption, pay taxes and imports, and save any leftovers and the cycle continues. This starts the
multiplier effect starts to increase AD. Although each consecutive increase in AD will be smaller than
its previous until the effect becomes 0. Therefore, the multiplier effect impacts the leakages in the
flow of income from taxation, imports, and savings.
 2. Analyse the likelihood of success of this policy, given the information provided in the case. 

The small marginal propensity to import (MPM) causes a multiplier increase and to have a bigger
impact on domestic output. If the new government decides to cut the income tax of households,
there will be an increase in demand for imported goods and services. This policy might boost
consumers’ confidence in the market, therefore encouraging households to spend more on
expenditures. Based on the circular flow model, this policy will strengthen the multiplier effect.

Due to the expected rise in household savings, households are predicted to save more of their
disposable income even income tax is cut. This causes the MPS to rise while decreasing the MPC. The
surge in MPS will have a lower economic impact when government spending or investment is
implemented. This also lowers the multiplier causes the circular flow of national income to drop,
simultaneously lowering the economy’s real GDP. This will dampen the impact of the multiplier.

When the economy’s trading partners’ real GDP is expected to soar, they will import more goods
and services. The demand for domestic exports will surge, causing the net export component to rise.
Moreover, more firms are also speculated to increase investment to push their output. Domestic
firms can export more volume of goods to the economy’s trading partner. The injection of exports
and investment strengthen the national income. The newly elected government could incentivize
more firms to improve production output by subsidizing their cost of production with their increase
in spendings.

Lastly, when firms’ investment levels are predicted to rise, they are required to employ more people
to accommodate the demand of production. This leads to more people being employed and lowers
the unemployment rate. Combined with the government’s policy on reducing income tax,
households have higher disposable income. More consumers will increase expenditures which then
those spendings will become income for other people. Consumption expenditure will then rise. will
be more effective due to higher injections of government expenditures, intensifying the multiplier
effect.

Overall, the policy mostly has a positive effect on the multiplier and its likely that the policy will be a
success. This will push the real GDP towards the potential GDP; hence it narrows the output gap.