Multiplier Effect: Understanding the Impact of Autonomous Spending | CFA Level 1 Exam Prep

The Multiplier Effect

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The multiplier effect refers to the fact that an autonomous change in spending (aggregate demand) will

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A. B. C. D. E.

E

The multiplier explains why small changes in investment, government or consumption spending triggers much larger changes in output.

The correct answer is E. The multiplier effect refers to the concept that an autonomous change in spending, also known as aggregate demand, will cause nominal output to rise by some multiple of the initial increase in spending.

When there is an increase in autonomous spending, such as increased consumer spending or government expenditure, it leads to an increase in aggregate demand in the economy. This increase in aggregate demand stimulates economic activity and has a multiplier effect on the overall output of the economy.

The multiplier effect works through the following mechanism: when there is an initial increase in spending, it leads to an increase in income for the recipients of that spending. These recipients, in turn, spend a portion of their increased income, which leads to further increases in spending and income for others. This cycle continues as each subsequent round of spending increases income and leads to further rounds of spending.

The multiplier effect is based on the idea that an increase in spending creates a chain reaction of additional spending throughout the economy. The size of the multiplier depends on the marginal propensity to consume (MPC), which is the proportion of each additional dollar of income that is spent. If the MPC is high, meaning people spend a large portion of their additional income, then the multiplier will be larger.

The multiplier effect can be represented mathematically as follows:

Multiplier = 1 / (1 - MPC)

For example, if the MPC is 0.8 (meaning people spend 80% of their additional income), the multiplier would be:

Multiplier = 1 / (1 - 0.8) = 1 / 0.2 = 5

This means that for every initial increase in spending, the total increase in output (or income) would be five times that initial increase.

Therefore, the correct answer is E. The multiplier effect causes nominal output to rise by some multiple of the initial increase in spending.

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