Answer to Question #140596 in Macroeconomics for Rolando Casaysay

Question

Explain the multiplier intuitively. Why is it that an increase in planned
investment of 100 pesos raises equilibrium output by more than 100
pesos?

Answer 1

Change in equilibrium output is higher than the change in planned investment. Output changes according to the change in planned investment. Suppose ∆Y is a change in equilibrium output and ∆I is a change in planned investment. Then ∆Y = ∆I×m. Here m is the multiplier and can be derived as the ratio of change in equilibrium output and change in planned investment. That means $m = \frac{∆Y}{∆I}$

If investment changes by 10 units, the equilibrium output will be changed by more than 10 units.

An increase in planned investment of 100 pesos will raise equilibrium output by more than 100 pesos due to the multiplier effect. An increase in planned investment means an increase in planned aggregate expenditure. Planned aggregate expenditure will be higher than the aggregate output. Companies will begin to increase output to adjust unplanned reductions in inventories. But if output increases the same amount as an investment, equilibrium remains at a disequilibrium state. When the output becomes, people earn more income and some part of the income goes for consumption. This will raise the planned aggregate expenditure in the future. To restore equilibrium output will increase further. That is why equilibrium output raises more than 100 pesos.