How does the aggregate expenditure multiplier change given a decrease in marginal propensity to import and marginal propensity to consume?
To understand how the aggregate expenditure multiplier changes given a decrease in the marginal propensity to import (MPI) and the marginal propensity to consume (MPC), we need to dive into the concept of the multiplier effect.
The aggregate expenditure multiplier measures the impact of changes in autonomous spending on a country's overall output or Gross Domestic Product (GDP). It represents the total increase in GDP resulting from an initial increase in autonomous spending.
The formula to calculate the aggregate expenditure multiplier is:
Multiplier = 1 / (1 - (MPC - MPI))
Where:
- MPC (Marginal Propensity to Consume) represents the portion of each additional dollar of income that people choose to spend rather than save.
- MPI (Marginal Propensity to Import) represents the portion of each additional dollar of income that is used to purchase imported goods and services.
Now, let's explore how the aggregate expenditure multiplier changes when both MPC and MPI decrease:
1. Decrease in Marginal Propensity to Import (MPI):
When the MPI decreases, it means that less of each additional dollar of income is used to purchase imported goods and services. This leads to a higher value of (1 - MPI), which influences the multiplier.
As (1 - MPI) increases, the denominator of the multiplier formula decreases, resulting in a higher multiplier. The decrease in MPI amplifies the impact of the initial increase in autonomous spending, leading to a larger increase in GDP.
2. Decrease in Marginal Propensity to Consume (MPC):
A decrease in the MPC implies that people consume a smaller portion of each additional dollar of income and save more. As a result, a larger portion of income leaks from the spending cycle, reducing the multiplier effect.
When MPC decreases, the numerator in the multiplier formula decreases, reducing the multiplier. With a lower MPC, the impact of the initial increase in autonomous spending diminishes, resulting in a smaller increase in GDP.
In summary, a decrease in the marginal propensity to import (MPI) increases the aggregate expenditure multiplier, amplifying the impact of an initial increase in autonomous spending on GDP. Conversely, a decrease in the marginal propensity to consume (MPC) reduces the aggregate expenditure multiplier, diminishing the impact of the initial increase in spending on GDP.