A. THE BASIC MULTIPLIER MODEL

When.economists attempt to understand why major increases in wartime military spending led to rapid increases in GDP,or why the tax cuts of the 19605 or 19805 ushered in long periods of business cycle expansions, or why the investment boom of the late 1990s produced America’s longest expansion, they often turn to the multiplier model for the simplest explanation.

What exactly is the multiplier model? It is a macroeconomic theory used to explain how output is determined in the short run. The name’ “multiplier” comes from the finding that each dollar change in exogenous expenditures (such as investment) leads to more than a dollar change (or a multiplied change) in GDP. The multiplier model explains how shocks to investment, foreign-trade, and government  tax and spending policies can affect output and employment in an economy. The key assumptions underlying the multiplier model are that wages and prices are fixed and that there are unemployed resources. In addition, we are suppressing the role of monetary policy and.assuming that there are no financial market reactions to changes in the economy.

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