(a) Explain what is the income multiplier and why is it greater than one? (b) Dr

Question

(a) Explain what is the income multiplier and why is it greater than one?

(b) Draw a diagram of the money market and explain how equilibrium is achieved in the money market. Explain with the aid of a separate diagram (for each part below), how the money market adjust to a new equilibrium interest rate when:

(i) a decrease in the money supply occurs.

(ii) an increase in money demand occurs.

(Be sure to explain what happens to bond prices in the process of adjustment to the new equilibrium interest rate)

Explanation / Answer

a) The multiplier is the proportionate increase in GDP that occurs due to a rise in expenditure in the economy (Government spending, for example, is usually the most common application of the multiplier - the "Government Expenditure Multiplier"). So, if the multiplier is 2, a 100 increase in Government spending would increase GDP by 200.

The multiplier is more than 1 because you have the initial increase in spending (100, say) PLUS the effect that a higher GDP has on other forms of expenditure. Mathematically (assuming closed economy):

GDP = Consumer Expenditure + Investment + Government Spending

Where both consumer expenditure and investment increase with GDP. So if you increase GDP by 100 by raising Government spending, you will raise both consumer expenditure and investment; hence the "multiplier" effect.

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