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Open Economy Autonomous Expenditure Multiplier Smaller than Closed Economy

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  • Last Updated : 24 Nov, 2021

When we discuss economics in-depth, we may split it into two more major categories: Open economy and closed economy. An open economy is one in which product exchange involves not only domestic elements (goods and services) but also entities from other nations. Managerial interchange, technological transfers, and all types of products and services are all examples of trade. It contrasts with a closed economy, which prevents foreign commerce and finance. A closed economy is one in which commodities and services are not exchanged with other nations. It’s indeed self-contained in a closed economy. It means that no imports or exports are allowed into or out of the nation. A closed economy’s objective is to fulfill all of a country’s consumers’ demands within its boundaries.

The multiplier’s value is determined by the following factors:

1. Consumption Propensity

The amount of the multiplier is mostly determined by the consumer’s proclivity to purchase. The multiplier impact increases as the tendency to use domestically produced products and services rises. Consumption propensity is influenced by factors such as the consumer’s income, wealth, pricing, and taxes. The government may adjust the amount of the multiplier by changing the tax rate, which affects people’s disposable income. This is because lowering the income tax rate will boost the amount of extra money available to spend on more goods and services.

2. Savings Propensity

After you’ve spent all of your money on consumption, you’ll have some money left over to save. The value of the multiplier has an inverse relationship with the proclivity to save. A larger proclivity to save means less money is available for consumption, and the multiplier impact of a change in any autonomous component decreases.

3. Import Propensity

The proclivity to buy imports is another element that influences the extent of the multiplier impact. If consumers spend a large portion of their excess income on imports, this demand is not passed on in the form of new spending on domestically produced goods. This is depicted as a leakage from the cyclical flow of income and spending, which diminishes the multiplier’s magnitude. This means that the multiplier will be smaller the higher the inclination to import.

4. Available Excess

One of the most significant requirements for the multiplier process is that there be enough spare capacity to create additional output. The complete multiplier effect is unlikely to occur if short-run aggregate supply (SRAS) is inelastic because increases in AD will lead to higher prices rather than a full gain in real national production. When SRAS is completely elastic, however, an increase in aggregate demand results in a substantial increase in national production.

5. The Amount of Overcrowding

Crowding out happens when the government’s expansionary fiscal policy fails to have the full multiplier impact on the economy owing to an increase in interest rates, crowding out private investment. We assumed investment (I) was self-contained in our study, however, it is governed by the interest rate. Any increase in the interest rate affects the amount of money available for investment. Increased government spending or reduced taxes, for example, might lead to an increase in government borrowing and/or inflation, which causes interest rates to rise and slows economic activity. More crowding out occurs when investment sensitivity to interest rates is larger.

The multiplier impact will be greater when:

  1. There is a strong desire to spend additional money on domestic products and services.
  2. The marginal tax rate on additional income is modest.
  3. There is a strong tendency to spend additional money rather than save it.
  4. There is a low proclivity to import as a result of increased cash.
  5. Consumer trust is strong (this affects willingness to spend gains in income).
  6. The economy’s businesses have the potential to grow production in response to rising demand.

Let’s have a look at the multiplier of both the economies:

The multiplier must be more than or equal to 1/MPC and 1/MPS. 

(Here, MPC means Marginal Propensity to Consume, and MPS means Marginal Propensity to Save.)

MPC should be equal to MPS for this to be true.

In the case of a closed economy:

1/1-MPC multiplier

or (because MPS = 1-MPC):

Multiplier=1/MPS

For an open market economy:

Multiplier= 1/1-MPC+MPM

or (because MPS = 1-MPC)

Multiplier=1/MPS+MPM

In an open economy, the multiplier is less due to the additional leakage factor MPM (Marginal propensity to import).

The components of this Keynesian model of income flow include national income, production, consumption, and factor payments, and they are commonly shown as a circle. Savings, taxes, and imports are examples of non-consumption uses of money that “leak” out of the main flow. This lowers the amount of money accessible to the rest of the economy. As previously discussed in open economies, there is an additional factor called MPM in the open economy that causes leakages by allowing income earned in one country to be transferred to another. The cash used to purchase the imports depart the nearby region, resulting in a domestic outflow. Savings, taxation, and imports are the three sources of leakage in a fully open economy. These are the marginal propensity to save (MPS) plus the excess income going to the government in the form of taxes plus the amount going overseas in the form of imports and expressed by the marginal propensity to import (MPM).

Conclusion:

Since a portion of domestic demand is spent on foreign items, the multiplier in an open economy is lower than in a closed economy. When compared to a closed economy, a rise in autonomous demand leads to a lesser growth in output. The extra money will now be spent on both domestic and imported items. The magnitude of the multiplier is further influenced by the tendency to import in an open economy, as both export and import take place. A smaller multiplier is associated with a strong proclivity to import.

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