Marginal propensity to consume and multiplier. The propensity to consume refers to the portion of income spent on consumption.
The MPC refers to the relation between change in consumption (C) and change in income (Y).
Symbolically MPC = ∆C/∆Y
The value of multiplier depends on MPC
Multiplier (K) = 1/1 – MPC
The multiplier is the reciprocal of one minus marginal propensity to consume.
Since marginal propensity to save is 1 – MPC. (MPC + MPS = 1).
Multiplier is 1/ MPS.
The multiplier is therefore defined as reciprocal of MPS.
Multiplier is inversely related to MPS and directly with MPC.
Numerically if MPC is 0.75, MPS is 0.25 and k is 4.
Using formula k = 1/1 – MPC
1/1 – 0.75 = 1/0.25 = 4
Taking the following values, we can explain the functioning of multiplier.
C = 100 + 0.8 y; 1 = 100 1 = 10
Y = C + I
Y = 100 + 0.8y = 100 + (1000) = 900;
S = 100 = I
After I is raised by 10, now I = 110
Y = 100 + 0.8y + 110
0.2y = 210
Y = 210 / 0.2 = 1050
Here C = 100 = 0.8 (1050) = 940; S = 110 = 1
Diagrammatic Explanation.
At 45° line y = C + S
It implies the variables in axis and axis are equal. The MPC is assumed to be at 0.8 (C = 100 + 0.8y) The aggregate demand (C + I) curve intersects 45° line at point E.
The original national income is 500.
(C = 100 + 0.8y = 100 + 0.8 (500) = 500)
When I is 100, y = 1000, C = 900;
S = 100 = I
The new aggregate demand curve is C+F = 100 + 0.8y + 100 + 10
Y = 210/0.2 = 1050
C = 940; S = 110 = 1
