2
$\begingroup$

My tutor said that only $I$, $G$, $X-M$ in AD can include a multiplier and that consumption does not create a multiplier effect. I understand that these factors affect my ability to consume and that one of these factors changing will affect my income and affect my MPC and create a multiplier. But, what if i take a loan? am i not creating further rounds of spending? I am increasing demand and increasing retailer incomes and increasing further rounds of spending so how is it not a multiplier?

$\endgroup$
1
  • $\begingroup$ Hi anon, can you provide more context to your question? E.g. it seems like you're referring to the IS-LM or AS-AD models. Maybe you can also provide the equation to which your questions refers. $\endgroup$ Commented Jan 28 at 12:50

1 Answer 1

2
$\begingroup$

I think either you misunderstood your tutor or they were not clear.

What they likely meant was that increase in total $C$ won’t be multiplied by multiplier. I think this is best seen mathematically. I will omit X-N to simplify the math a bit and use the AD in an closed economy:

$$Y= C+I+G$$

Next what your tutor assumes implicitly is that both $I$ and $G$ are exogenously given, this is standard simplification assumption for beginners but it’s worth while noting that especially for $I$ this is generally not the case.

Next consumption depends on net income and it will be given by:

$$ C(Y-T)= c_0 +c_1 (Y-T)$$

Where $c_0$ is autonomous consumption (special type of consumption that does not depend on income) $c_1$ is marginal propensity to consume, $Y$ is the aggregate income which is macroeconomically equivalent to AD and output, finally T are taxes (taxes are sometimes also dropped to simplify things for students so maybe you were not introduced to them).

So now our model looks like this:

$$Y= c_0 +c_1 (Y-T)+I+G$$

Since $Y$ is on both sides of equation we first have to solve for $Y$ to see clearly the effect different variables have on $Y$. Using simple algebra we find:

$$Y= \frac{1}{1-c_1}\left(c_0 +I + G - c_1 T\right)$$

The fraction $\frac{1}{1-c_1}$ is the multiplier, and only variables in the bracket affect the AD via the multiplier. As you can see in bracket there is no $C$ because $C$ was endogenous and dependent on income so it is not $C$ that drives higher income/AD but higher income/AD itself. There is self reinforcing loop, although this effect gets smaller through each circle (since MPC cannot be bigger than 1).

However, what I think your tutor did not appropriately explain is that AD still depends on the autonomous portion of consumption $c_0$. So some consumption does have this effect, but if we talk about aggregate consumption $C$ then no because $C$ is ultimately driven by $Y$.

Next you are probably asking why $I$ isn’t also driven by $I$ and that’s a good question, in real life it almost certainly is, save some special circumstances like liquidity trap, but in class when you learn the model for the first time $I$ will be assumed independent of income so the model solves easier. Later on you will see that when $I$ will be dropped from the solution.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.