Question

Explain the multiplier process.

Short answer

The multiplier process refers to the mechanism by which an increase in spending leads to a greater increase in income. This starts from a rise in autonomous spending which results in increased income and consumption. The cycle continues until the total increase in income is multiple times the initial increase in spending. The simple multiplier can be calculated by the formula \(Multiplier = 1 / (1 - MPC)\), where MPC is the Marginal Propensity to Consume.

Step-by-step solution

Understand the Concept of Multiplier

The multiplier process refers to the mechanism by which an increase in spending (which could be consumption, investment, government spending, or net exports) leads to a larger increase in income. It indicates the ratio of change in income to the change in investment.

The Simple Multiplier Process

In a simple multiplier process, suppose there is a rise in autonomous spending, for instance, investment. This increase in investment raises income. The rise in income further leads to an increase in consumption which again elevates income and hence consumption. This chain continues until ultimately the total rise in income is multiple times the initial rise in investment. The simple multiplier can be calculated by the formula: \[Multiplier = 1 / (1 - MPC)\] where MPC stands for Marginal Propensity to Consume.

The Multiplier Effect on Total Income

To relate this back to the economy as a whole, the multiplier process illustrates how an initial change in spending can lead to a larger final change in total income. This starts a cycle of spending and income increases, which eventually stabilizes as the amount of spending decreases with each round of the cycle due to factors such as savings, taxes, and imports.