The multiplier effect

Consider a hypothetical economy where there are no taxes and no international trade. Households spend $0.50 of each additional dollar they earn and save the remaining $0.50. If there are no taxes and no international trade, the oversimplified multiplier for this economy is

.

Suppose investment spending in this economy decreases by $100 billion. The decrease in investment will lead to a decrease in income, generating a decrease in consumption that decreases income yet again, and so on.

Fill in the following table to show the impact of the change in investment spending on the first two rounds of consumption spending and, eventually, on total output and income.

Change in Investment SpendingChange in Investment Spending = = −$100 billion−$100 billion
First Change in ConsumptionFirst Change in Consumption = = billion
Second Change in ConsumptionSecond Change in Consumption = = billion
∙• ∙•
∙• ∙•
∙• ∙•
Total Change in OutputTotal Change in Output = = billion
Now consider a more realistic case. Specifically, assume that the government in our hypothetical economy collects income taxes. In this case, the multiplier will be the oversimplified multiplier you found earlier.

Suppose that the price level in our economy remains the same and that there is still no international trade. Now, however, the government decides to implement an income tax of 5% on each dollar of income. The MPC and MPS, however, remain the same as before. In this case, after accounting for the impact of taxes, the multiplier in this economy is , and a $100 billion decrease in investment spending will lead to a billion in output.