What Is the Multiplier Mechanism?
It was observed in the previous segment that with a change in the independent expenditure of 10 units, the change in the equilibrium income was equal to 50 units (from 250 to 300). We can comprehend this by looking at the multiplier mechanism, which is elucidated as follows:
The manufacturing of final commodities employs factors such as capital, labour, land, and entrepreneurship. In the absence of indirect taxes or subsidies, the total value of the final commodities output is allocated among distinct factors of manufacturing: interest to capital, rent to land, wages to labour, and more. The remaining amount is budgeted by the entrepreneur and is known as profit.
Hence, the sum total of average factor payments in the economy, or the national income is equivalent to the average value of the output of the final commodities and the Gross Domestic Product (GDP).
In the given instance, the value of the extra output, i.e., 10, is allocated among distinct various factors as factor payments and therefore, the income of the economy increases by 10. When income goes up by 10, the utilisation or consumption expenditure increases by (0.8)×10 , since people spend 0.8 (= mpc) fraction of their additional earnings on utilisation.
Therefore, in the next round, the average demand in the economy increases by (0.8)×10. This, in turn, leads to an excess demand equal to (0.8)×10.
Therefore, in the next manufacturing cycle, the manufacturers increase their planned output further by (0.8)×10 to reinstate equilibrium. When this additional output is allocated among various factors, the income of the economy increases by (0.8)×10 and the utilisation demand increases further by (0.8)2×10, once again creating an excess demand of the same amount.
This procedure goes on, round after round, with manufacturers increasing their output to clear the excess demand in each round and customers spending a part of their additional income from this extra manufacturing on utilisation items; hence, creating further excess demand in the next round.
This concept explains in detail about the concept of multiplier mechanism for the class 12 Macroeconomics. To know more, stay tuned to our website.