Macro economics – the multiplier

The multiplier effect is related to changes in aggregate demand that result from “amplification of initial changes in expenditure” (Colander, 2008, p. 207). Unlike the microeconomics perspective where a constant may be assumed for other effects resulting from initial effects, in macroeconomics such secondary effects are taken into account (Colander, 2008). As such the initial changes are viewed, in macroeconomics, to result into further changes hence an amplification of effects – multiplier effect – arises (Colander, 2008).

The multiplier effect in an AD/AS model

multiplier

 

The AD curve slopes downwards as the price levels fall from P0 to P1. Since the aggregate demand (AD) is comprised of consumption (C), investment (I), government spending (G) and net exports (NX); aggregate demand’s response to changes in price level is determined by how its composite factors change in respect to these price changes (Colander, 2008). Specifically expenditures on C, G and NX increase with decreasing prices (Colander, 2008). As such the aggregate demand will increase with decrease in price levels primarily as a result of factors such as wealth, interest rates and international effects.

Wealth effects represent the concept that with falling price levels, people will be able to purchase more quantities of a product with same quantities of currency – increased purchasing power of the currency (Colander, 2008). Such increased consumption expenditures increase the component demand because they form part of it – thus the slope towards the left (Colander, 2008). Increased purchasing power will further make people to perceive that they are holding more money than they need thus, they deposit the extra amounts thus availing more lending funds for the banks (Colander, 2008). Increased lending results in reduced interest rates promoting investment expenditures as businesses and individuals realize investment funds are being availed at lower costs (Colander, 2008). Such increased investment increases aggregate demand since it is one of its components (Colander, 2008). A similar effect of price declines on AD results from international effects. If the exchange rate remains stable, price reductions increases competitiveness of domestic products relative to foreign products thus increasing export and decreasing imports (Colander, 2008). The increased net exports increase the aggregate demand since net exports is one of the components of AD. The multiplier effect (Y1 – Ye) results from amplification of these initial effects (Y0 – Y1). Such amplification results into a flatter AD curve – increased aggregate demand – than would have been when these secondary effects are not taken into account (Colander, 2008). Go to part 6 here

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