2019 Nov (Multiplier GDP) Paper 1 HL

 2019 Nov (Multiplier GDP) Paper 1 HL

(4) (a) Explain the effect an increase in investment might have on RGDP using the Keynesian multiplier.

 

Definitions

RGDP – Real GDP is an inflation-adjusted measure that reflects the value of all goods and services produced in an economy in a given year (expressed in base-year prices) and are often referred to as “constant-price”, “inflation-corrected”, or “constant-dollar” GDP.

Investment – addition of capital stock to the country

 

Keynesian Multiplier - below

(AD to AD1 is the initial increase in investment but then the multiplier effect pushes AD to AD3. Therefore the RGDP (Real Output) also increases)

An initial increase in investment, a component of AD, leads to multiple successive increases in AD and RGDP.

 

Explanation – When there is an injection into the system (government expenditure, investment) incomes increase by the amount of the injection at first. However, the increase does not stop there. Assume MPC = 0.5, such that 50% of the additional household income is spent on consumption. With an initial injection of $100, total income increases by $100. The $100 is then paid out to households as factor income (wages) by firms. Household income increase by $100. As MPC is 0.5, households spend 50% of their income, which is $50 spent as consumption expenditure to firms then firms gain $50 and again pay $50 as factor income to household (workers). From the $50 income households now spend $25 on consumption.

 

This in essence is the Keynesian Multiplier formula 1/(1-MPC) or 1/MPS, if the MPC = 0.5 then the MPS = .5 therefore 1/.5 = 2 and the 2 is the Multiplier.

 

An initial increase in investment of $100 x 2 = $200 is the total income (RGDP) generated by the initial increase in income (investment) of $100.