Question

Why is the actual multiplier in the U.S. economy less than the multiplier in this chapter’s example?

Short answer

An actual multiplier is less than the one in the chapter because the actual multiplier also includes the impact of taxes, imports, output, and inflation which reduces the impact of change in spending on the real GDP.

Step-by-step solution

Difference between actual multiplier and textbook multiplier

As explained in the textbook, the multiplier concept assesses the impact of change in investment, government purchases, and consumption only on the change in GDP.It is based on the MPC and MPS for change in income. It ignores all the other factors which influence the real GDP.

$$\begin{gathered} k=\frac{1}{MPS} \\ k=\frac{1}{1-MPC} \end{gathered}$$

The actual multiplier effect depends on the income not spent on domestic output as well. This is because the multiplier's increase in income is further invested in imports and additional taxes rather than the domestic output. Thus, it includes the impact of imports and taxes as well.

Reason for the difference in size

The actual multiplier assesses the impact of change in all the components of GDP on the real GDP like taxes, imports, output, and inflation.

The increase in income by investment or any other expenditure component other than net exports is spent by households on imports. Additionally, the imports increase the burden of taxes on the national income. The amount spent on imports and the additional taxes drains domestic income. Therefore, the overall income decreases.

Moreover, the increase in income may not necessarily denote an increase in output. The increase in income could result from inflation. Therefore, the 1/MPS formula overstates the real GDP.

The actual multiplier considers all these factors that reduce the change in real GDP (Y = C + I + NX). A smaller change in real GDP will be there because of the lower actual multiplier. Therefore, the actual multiplier in the U.S. economy is less than that calculated in textbooks.