2.4 - The multiplier

Question 1

Multiplier ratio

Answer 1

• Measures the number of times an original injection into the circular flow (or an increase in AD) is multiplied to become an even bigger increase in national output/national income
  > It is the ratio of the final change in income to the initial change in injection ; and the figure multiplied by the original injection to find the final change in income.

Question 2

Multiplier formula

Answer 2

Multiplier = 1 / (1 - MPC)

Alternatively, Multiplier = 1 / MPW, where MPW (Marginal Propensity to Withdraw) = MPS + MPT + MPM.

Question 3

The multiplier process

Answer 3

• Initial Spending: An initial increase in spending (e.g., government investment, export demand) injects money into the economy.
• Income Generation: This spending becomes income for households and firms, who then spend a portion of this income.
• Secondary Spending: The subsequent spending generates additional income for others, continuing the cycle.
• Diminishing Returns: Each round of spending is smaller due to withdrawals (savings, taxes, imports), eventually tapering off.

Question 4

Effects of the Multiplier on the Economy

Answer 4

• Economic Expansion:
  > The multiplier amplifies the effects of initial spending increases, leading to greater overall economic growth.
  > Job Creation: Increased demand for goods and services requires more labour, reducing unemployment.
  > Income Growth: Higher demand raises incomes, enhancing living standards.

Economic Contraction:

• Conversely, a reduction in spending can have a multiplied negative impact, leading to deeper recessions.
  > Increased Unemployment: Lower demand reduces the need for labour, increasing unemployment.
  > Decreased Income: Reduced economic activity leads to lower incomes and consumption.

Question 5

Marginal propensity to consume (MPC)

Answer 5

• The fraction of additional income that households spend on consumption.
• Higher MPC results in a larger multiplier as more income is recycled into the economy.

Question 6

Marginal Propensity to Save (MPS)

Answer 6

• The fraction of additional income that households save.
• Higher MPS leads to a smaller multiplier as more income is withdrawn from the spending cycle.

Question 7

Marginal Propensity to Tax (MPT)

Answer 7

• The fraction of additional income that is paid in taxes (gets taxed)
• Higher MPT reduces the multiplier as more income is diverted to the government.

Question 8

Marginal Propensity to Import (MPM)

Answer 8

• The fraction of additional income spent on imports instead of domestically produced goods
• Higher MPM decreases the multiplier as income leaks out of the domestic economy.

Question 9

Effects on the Multiplier:

Answer 9

A high MPC and low MPS, MPT, and MPM result in a larger multiplier.
Conversely, a low MPC and high MPS, MPT, and MPM lead to a smaller multiplier.

Question 10

Formulas for multiplier

Answer 10

• Formula 1:

Multiplier = 1 / (1 - MPC)

Formula 2:

Multiplier = 1 / MPW

Question 11

How do you calculate MPW?

Answer 11

MPW = MPS + MPT + MPM.

Question 12

The Significance of the Multiplier for Shifts in AD

Answer 12

The multiplier effect means that an initial increase in AD results in a larger overall increase in national output and income.

Question 13

Policy Implications of the multiplier

Answer 13

• Understanding the multiplier helps policymakers design effective fiscal policies to manage economic cycles.
• Stimulus Measures: Governments can use fiscal stimulus to combat recessions, knowing the multiplier effect will amplify the impact.
• Austerity Measures: Conversely, cutting spending can have a larger-than-expected negative impact due to the multiplier.