In an open economy, why is the investment spending multiplier smaller than in a closed economy?

• A. Exchange rate adjusts to offset investment.
• B. Government spending crowds out private investment in open economy.
• C. Fiscal multiplier is always bigger in open economies due to trade.
• D. Some demand leaks into higher imports, so the domestic spendable portion is reduced.

Answer: (D)

When investment rises, output grows through a chain of spending rounds. In a closed economy all the extra spending stays within the country and keeps circulating, so the total impact on domestic output is larger. In an open economy, part of the extra income is spent on imports. That is a leakage from domestic demand—the money leaves for foreign goods and services rather than fueling domestically produced output. Because some of the spending is diverted abroad, each round of the spending process has less effect on domestic production, so the overall increase in domestic GDP is smaller.

A simple way to see it is that the open-economy multiplier is smaller because imports absorb part of the demand. If you think in terms of the formula, the multiplier becomes 1 / (1 - c + m), where c is the marginal propensity to consume domestically and m is the marginal propensity to import. Since m is positive, the denominator is larger than in the closed-economy case, giving a smaller multiplier.

That’s why the correct idea is that some demand leaks into higher imports, reducing the domestic spendable portion and producing a smaller investment multiplier.