Question

give a real-world (or hypothetical) example of how the spending multiplier works. You might want to include some numbers to help support your example.

Answer 1

Spending multiplier is the concept that shows that maximum impact that can be made upon the output with increase or decrease in spending. Spending multiplier is used to calculate on the basis of marginal propensity to consume (MPC). A bigger MPC means a bigger spending multiplier.

Spending multiplier has following formula:

Spending multiplier = 1/(1-MPC)

Let, MPC = .80

Then,

Spending multiplier = 1/(1-.80)

Spending multiplier = 5

Now suppose, government increases the spending by $100 Billion, then:

Maximum increase in real GDP = increase in spending * Spending multiplier

Maximum increase in real GDP = 100*5

Maximum increase in real GDP = $500 Billion

Now, it can be observed that increased spending of $100 Billion, has multiplier effect on real output to increase to the level of $500 Billion. It is due to the spending multiplier.