Chapter Eleven: Module Summary -- The Output Multiplier

• When an autonomous component of Aggregate Demand changes, equilibrium output will change by more than the initial change in demand. This result is known as the multiplier effect.

• The size of the multiplier effect is given by: Change in Output = (output multiplier) x initial change in AD, where the (simple) output multiplier is defined as 1/(1-MPC).

• A Proportional tax is a tax that varies with the level of income. The formula for the output multiplier when proportional taxes are present is: 1 / (1 - MPC (1-t)).

• Proportional taxes reduce the size of the multiplier because they lower disposable income in each round of the multiplier.

• We define the Marginal Propensity to Import (MPI) as the change in imports divided by the change in disposable income. Assuming no proportional taxes but including imports, the output multiplier formula is 1 / (1 - MPC + MPI).

• Just like taxes, the propensity to import tends to lower the multiplier effect because demand for domestically produced final goods and services falls.

• When the AD curve shifts and the AS curve is upward sloping, the multiplier effect is smaller. This is because AD is partially dampened as the price level rises.

• The dynamic impact of the multiplier depends upon whether the change in Aggregate Demand is temporary (a one-time expenditure), or permanent (a permanent period after period increase in Aggregate Demand).

• A temporary rise in Aggregate Demand will have short-run multiplier effects, but equilibrium output will return to its initial level after all the multiplier effects are completed.

• A permanent rise in Aggregate Demand will have permanent effects on the equilibrium level of output. Equilibrium output will rise by the multiplier times the initial change in Aggregate Demand.