Final answer:
Incremental budgeting is a method where the budget is based on the previous year's figures, increased by a set percentage. It reflects the compound growth of an initial amount over time, similar to the growth of savings with interest or a country's GDP with its growth rate. The power of compounding over time can have a significant impact on future financial projections.
Step-by-step explanation:
The approach to budgeting where the financial database of the immediate past year is increased by a set percentage for the coming year is termed incremental budgeting. This method assumes an original starting amount like the previous year's budget and adds to it using a specific percentage increase.
This process is akin to how an amount of financial saving grows over time with a certain interest rate. Similarly, the approach can reflect how a country's GDP grows at a certain growth rate over time.
To understand this approach's impact, one can use a formula to calculate the multiplier effect, which shows how an initial expenditure's increase affects subsequent rounds of spending. For example, if a person were to save an amount of money, say $100,000, with a 9% interest rate over 30 years, it would compound to $1,327,000, illustrating the impact of the interest rate over time.
Calculating the Multiplier helps us understand the implications of changes in the rate of return on savings or investment. For instance, if Yelberton received a higher rate of return, his future consumption potential would significantly increase, as a higher interest rate causes the budget line to pivot upward on the intertemporal budget constraint.