Which concept explains how initial spending leads to a larger overall change in spending throughout the economy?

• A. CPI
• B. Recession
• C. Fiscal policy
• D. Multiplier effect

Answer: (D)

The key idea here is the spending multiplier: one initial injection of spending creates income for someone else, and that person is likely to spend part of that new income as well. That additional spending becomes income for others, who also spend a portion, and so on. Each round of spending feeds into the next, so the total change in spending across the economy is larger than the initial amount.

The size of this amplification depends on how much of any extra income people consume, known as the marginal propensity to consume. If people spend most of extra income (a high MPC), the multiplier is larger; if they save more (a low MPC), the multiplier is smaller. In a simple case, if the MPC is 0.8, the spending multiplier is 1 / (1 - 0.8) = 5, so an initial $100 of spending could increase total spending by about $500.

This concept explains why relatively small changes in autonomous spending (like government purchases or investment) can lead to much larger overall changes in aggregate demand. The other terms listed aren’t about this amplification mechanism: the CPI measures price changes, recession is a downturn in the business cycle, and fiscal policy is the policy tool that can trigger spending and its multiplier but isn’t the amplification process itself.