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In a closed economy, all monies spent are received by fellow citizens, therefore there is no "leakage" of funds from the economy to other economies.
where MPS is the Marginal Propensity to Save.
If you know the MPC, you know the MPS, because MPC + MPS = 1.
If the MPC is 0.8, then the MPS is 0.2
Using the formula, 1 ÷ 0.2 = 10 ÷ 2 = 5
If the MPS is 0.5, then the Multiplier is 1 ÷ 0.5 = 10 ÷ 5 = 2
Once again, assume MPC = 0.8 (therefore MPS = 0.2). The national norm in Ireland has been to spend approximately 40% of all extra income on imports. This would give us, historically, an MPM of 40% or 0.4
Applying these figures, the formula becomes
1 ÷ (.2 + .4) = 1 ÷ .6 = 1.666...
Multiplier = 1.666...
This means that an injection of 1,000 Euro will become 1666.66 Euro by the time the injection has worked its way through the economy.
It is very easy to see the effect which the payments for imports has on an economy.
Without imports, i.e., in a closed economy with an MPC of 80%, there is a multiplier of 5
When imports are brought into the equation for the open economy model, the multiplier is reduced to 1.66...
If we have an MPC of 50%, then we also have an MPS of 50%, so our Multiplier Formula for an Open Economy would now be
1 ÷ (.5 + .4) = 1 ÷ .9 = 1.1111 ...
Multiplier = 1.111 ...
An injection now of 1,000 Euro would only yield 1,111 Euro by the time it works its way through the economy.
The Paradox of Thrift is still evident. The more we save the less well off the economy is, while the more we spend the wealthier it is. |
Pity about the imports, though. Imports, however, are not necessarily bad. When we spend money on imports we may be importing essential raw materials which are not available in the country, e.g., oil. We may also, however, be importing luxury consumer items. It is the latter that we could try to curtail if we wished to increase the wealth of the country in real terms.
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