When there is an increase in the components that back up aggregate demand, there will be an increase in real GDP. However, the actual increase is likely to be much larger than the initial increase. The multiplication of effect is called the Keynesian multiplier. We explain the phenomenon with an example. Assume there is an initial increase in spending of 8 million dollars. The increase creates further chain of spending called induced spending. The spending translates to income for owners of factors of production, when use it as their consumption spending. The cycle repeats, increasing the GDP beyond the 8 million amount. The way the 8 million dollars are spent is divided into four parts: Marginal propensity to:
- Consume, save, tax and import. Use infinite geometric sum again, just like Minimum reserve requirements. The parts that are not MPC are leakages.
Note that the multiplier effect can only be initialed by a change in spending that is not caused by a change in income. Changes in income are simply reallocations of existing income, and therefore does not change aggregate demand. There is also the assumption that price levels are constant, like a horizontal supply curve. Otherwise each increment will equate to less and less.