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    I am having some trouble understanding the multiplier effect. There are two main things I don't understand:

    1) The effect is explained with an example in which there is a £100 million increase in investment. A firm receives the money from the investment. All of the money is then passed onto households. The households withdraw some of the money, in this case at a rate of 0.1, meaning £90 million flows back to firms. What I don't understand is why ALL the money firms receive must flow back to households, and why when calculating the multiplier, you only take into account the MPW of households. Surely firms save, import and pay taxes. Why are these withdrawals not included in the model?
    2) I was taught beforehand that the MPC and the MPS must equal 1, as income is either spent or saved. Why is it then that the value of the multiplier is 1/1-MPC or 1/MPW, which suggests that the MPC and the MPW equal one. This makes more sense, but why was I taught it in terms of the MPS and MPC equalling 1 beforehand?

    Thanks in advance for any help. I understand the concept in general but just a few details don't seem to make sense.
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    (Original post by 11owolea)
    I am having some trouble understanding the multiplier effect. There are two main things I don't understand:

    1) The effect is explained with an example in which there is a £100 million increase in investment. A firm receives the money from the investment. All of the money is then passed onto households. The households withdraw some of the money, in this case at a rate of 0.1, meaning £90 million flows back to firms. What I don't understand is why ALL the money firms receive must flow back to households, and why when calculating the multiplier, you only take into account the MPW of households. Surely firms save, import and pay taxes. Why are these withdrawals not included in the model?
    2) I was taught beforehand that the MPC and the MPS must equal 1, as income is either spent or saved. Why is it then that the value of the multiplier is 1/1-MPC or 1/MPW, which suggests that the MPC and the MPW equal one. This makes more sense, but why was I taught it in terms of the MPS and MPC equalling 1 beforehand?

    Thanks in advance for any help. I understand the concept in general but just a few details don't seem to make sense.
    The circular flow of income model is very basic, and can be used to demonstrate the multiplier effect. Firms can save, import and pay taxes, but the multiplier effect doesn't take those into account. It is more like a theoretical effect in the sense that saying we don;'actually know the actual effect of the spending by government, because of a variety of things, including the 3 things you mentioned.

    MPW = Marginal propensity to save, be taxed and import
 
 
 
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