a. Explain the concept of the multiplier, and explain the role of the marginal p

Question

a.   Explain the concept of the multiplier, and explain the role of the marginal propensity to consume in determining the size of the multiplier.

Explain how the size of the multiplier will change when the role of the marginal tax rate is brought in.

Using the concepts in parts a and b above, calculate the slope of the AE curve and the size of the multiplier if MPC = 0.75. Then calculate the revised slope of the AE curve and the multiplier when you know that the imports and the marginal tax rate will reduce the slope of the AE curve by another 0.10.

Explanation / Answer

a. Though the concept of multiplier was developed by F.A. Kahn, it was J.M. Keynes who refined

it. Kahn’s multiplier was called employment multiplier, whereas Keynes’ multiplier is popularly known as the investment or income multiplier. The crux of the concept of the multiplier is that the total increase in income, output or employment is several times the original increase in income. The multiplier is, therefore, the increment in income to the increment in investment. The increase in income can be expressed in the form of an equation:

Y = I*1/(1-MPC) or

Y/I = 1/(1-MPC)

Y/I measures the size of the multiplier, and therefore, the size of the multiplier is k = 1/(1-MPV). It is, therefore, clear that the size of multiplier depends upon the marginal propensity to consume of the community.

The marginal tax rate does not directly affect aggregate expenditure, but indirectly through disposable income and consumption. Since the multiplier is the negative of MPC times one minus the slope of the aggregate expenditure line, the larger the slope the larger will be the multiplier.

Multiplier = 1/(1-MPC) or 1/MPS

If MPC is 0.75, MPS = 1 – 0.75 = 0.25

The multiplier will be = 1/0.25 = 4

The slope of the AE will be 4.

If imports and marginal tax rate reduce the slope of the AE by 0.10, then the slope of the new AE will be (0.25+0.1) = 0.35

The revised slope of the AE = 0.35

New multiplier = 1/0.35 = 2.85.

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