# Experiment 5 The multiplier process

## 5.5 Student instructions

Each participant in this experiment represents one household in an economy. In each of the 10 rounds, your only task is to determine the level of consumption for your household. At the same time, the other participants determine the levels of consumption for their households.

Production is organized by Linda, a central producer whose behaviour is determined by the computer.

Linda collects information on the level of consumption by all households and sets the level of production according to aggregate demand. Aggregate demand consists of all households’ level of consumption plus aggregate investment. Aggregate investment is produced by Linda, amounting to 100 per household.

Each household works an identical amount to produce aggregate demand and achieves an income by selling its labour to Linda. Linda sells her produced goods to the households according to their level of consumption.

While deciding on consumption you do not know your household’s income. The total economy’s income depends on Linda’s production and, thus, aggregate demand. This in turn is determined by all households’ consumption, plus investment. Each household gets an equal share of total income. As a consequence, for each household, income is given by

You should aim to set consumption for your household close to a target. This target is a share of your household’s income and the remaining share is saved. The target for consumption is: TARGET = 0.8 × INCOME. The participant whose consumption comes closest to the target over all rounds is declared the winner.

## 5.8 Homework questions

1. Your instructor shared with you the results of the game that you played.
1. Determine the equilibrium level of consumption and income if investments are fixed to 100.
2. Explain the development of consumption over time and give reasons for the slow adjustment.
2. Your instructor shared with you the consumption data from the experiment. Take the five highest and the five lowest consumption choices from the first round. Calculate their level of savings. What can you conclude about the overall level of savings?
3. Read Section 14.2 in The Economy and draw Figure 14.2 for the values of the game played in class. What can you conclude about autonomous consumption?
4. Consumption is C = c0 + c1 × Y and Y = C + I. Solve the system for the equilibrium values of C, S, and Y. What can you conclude if the consumption rate c1 is equal to 0? What happens if the consumption rate is 1?
5. For this exercise you will need the Multiplier Model Excel Simulator. Assume that in this economy, net exports are zero and taxes are levied as a proportion of income.

We are going to start by using the Excel Simulator to consider the effect of a 100% increase in investment when the marginal propensity to consume (MPC) is 0.5.

1. Figure 1 in the Simulator shows the standard multiplier model from Section 14.2. Label the initial goods market equilibrium (GME) with an A and the new GME with a Z. Explain what it means when the economy is in goods market equilibrium.
2. How does Figure 2 relate to Figure 1? (Hint: look at the labels on the axes)
3. Now label the initial GME on Figure 2 with an A and the new GME with a Z.

Figure 3 shows a breakdown of the changes happening to investment, income-dependent consumption, and output (income) over time or in each ‘spending round’.

1. Write down the aggregate demand equation for this economy. Identify investment and income-dependent consumption in the equation.
2. Recall the definition of MPC. Explain what it means when the MPC is 0.5.
3. The first change in income-dependent consumption happens in spending round 2 and has a value of 5. Explain why. (Hint: you might find it helpful to look at the aggregate demand equation you wrote down for question d.)
4. What is the value of the next change in income-dependent consumption? Explain why.
5. What is the link between the changes in Y, investment, and income-dependent consumption?
6. Now sketch what a line showing the changes in aggregate demand would look like on Figure 3. (Hint: Think carefully about the timing and the GME.)

Now let’s look at the importance of the MPC.

1. Change the MPC value firstly to 0.2, then to 0.8. Describe and explain the changes to all three figures in each case.

Economists use models like this to make projections or forecasts of how changes to components of aggregate demand will affect GDP.

1. Imagine the UK economy is in recession and that the government is uncertain about the proportion of credit-constrained households, so estimates a range for the marginal propensity to consume from 0.5 to 0.65. What is the forecast range for the change in GDP, in percent, due to a 5% rise in investment as a consequence of some favourable government policies?
2. In the Simulator, we used a single number to represent the MPC of the entire population, but in reality, the MPC may differ between individuals. Suggest some reasons why people might have different marginal propensities to consume. In your answer, propose four households of different ages, employment status (such as employed, unemployed, retired), and home ownership status (such as renter, home owner with no mortgage, home owner with a mortgage) and explain why you think the MPC would vary across these households.
3. Use your results in k. and l. to comment on the relationship between a recession, credit constraints, household characteristics, the MPC, and the effectiveness of government policy.