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
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(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.
