Question

Suppose the following information regarding some aggregate economy:

Consumption: 200 + 0.75Y

Investment: 100 + 0.10Y

Government Spending: 500

Exports: 100

Imports: 50 + 0.25Y

Compute the Keynesian multiplier for this economy. Explain (i) its meaning (causes and consequences), and (ii) why is it larger than 1 but not infinite

Answer 1

Use AE = C + I + G + NX

AE = 200 + 0.75Y + 100 + 0.10Y + 500 + 100 - 50 - 0.25Y

AE = 850 + 0.60Y

Keynesian multiplier = 1/1-0.60 = 2.5

This implies that when aggregate expenditure by $1, income rises by $2.5. As and when the government uses its spending to end the recession, the increase in government spending is multiplied due to the multiplier and income is increased by multiple times.

It is greater than 1 because one part of disposable income is consumed domestically, one other part is spent on imports and the remaining is saved. Hence the denominator is always less than 1 so that overall the multiplier is always 1. It cannot be infinity because some portion of increased income goes to consumption definitely.