2.4.4 The Multiplier

Question 1

The multiplier ratio

Answer 1

The ratio of change in real income to the injection that created the change.

Question 2

What idea is the multiplier process based on?

Answer 2

That one individual’s spending is another individual’s income.

For example:

An increase in consumption immediately increases AD.
- Store owners who have benefited from the extra consumption now have extra income.
- They spend some of that income on goods/services.
- Their expenditure on goods/services is now income for the next tier of individuals.
Due to the successive rounds of spending, the final increase in national income is much larger than the initial injection.
The size of the multiplier is entirely dependent on the size of leakages that occur during the process – the higher the leakages, the smaller the multiplier.

Question 3

What will the multiplier effect do to AD?

Answer 3

The initial injection shifts AD to the right. The result of the multiplier is that there is a secondary movement of AD to the right which (if the multiplier were 2) may be double the initial movement.

(The initial investment has more than 1 impact on AD).

Question 4

Marginal Propensity to Consume (MPC)

Answer 4

The proportion of additional income that is spent.

Question 5

Marginal Propensity to Save (MPS)

Answer 5

The proportion of additional income that is saved.

Question 6

Marginal Propensity to Tax (MPT)

Answer 6

The proportion of additional income that is paid in tax.

Question 7

Marginal Propensity to Import (MPM)

Answer 7

The proportion of additional income that is spend on imports.

Question 8

The effects of Marginal Propensities on the Multiplier

Answer 8

The marginal propensities are calculated for economies and provide insights into how each additional $ of income is allocated.

For example, Sweden has a higher tendency to save than the USA.
- Their marginal propensity to save is higher.
- The USA, therefore, has a greater multiplier on any injections into the circular flow.

Question 9

How can the value of the multiplier be calculated?

Answer 9

Question 10

If taxes increase, what will happen to the value of the multiplier?

Answer 10

The multiplier reduces (because the MPT increases, meaning more money is withdrawn from the circular flow)

Question 11

If interest rates increase, what will happen to the value of the multiplier?

Answer 11

The multiplier reduces, because interest rates cause savings to increase and consumption in the economy therefore decreases.

Question 12

If exchange rates appreciate, what will happen to the value of the multiplier?

Answer 12

The multiplier reduces, because the level of imports will increase (which is a withdrawal from the circular flow).

Question 13

If confidence in the economy increases, what will happen to the value of the multiplier?

Answer 13

The multiplier increases because consumption increases in the economy as condifence is higher.

Question 14

Why does the IMF only lend money for infrastructure?

Answer 14

The International Monetary Fund (IMF) lends countries money for infrastructure projects because they are virtually guaranteed to have a significant positive multiplier effect meaning the loan can be repaid in full, in addition to improving the country’s economy - unless there is corruption!

Question 15

What is the safest investment for governments?

Answer 15

Infrastructure – because it has a high multiplier effect (due to the jobs in the supply chain, and the positive effects of building the infrastructure).

For example, Joe Biden’s $1 trillion bill in 2021.

Question 16

Cost-benefit analysis (CBA)

Answer 16

Where economists weigh up the costs and the benefits that will come from spending. This happens both in governments and in firms.

The cost-benefit analysis determines whether the multiplier effect makes a government project worthwhile. This is not definitive and can be looked at in different ways.

Question 17

Key evaluation point on the effectiveness of the multiplier effect

Answer 17

Time lag: It may take up to 18 months for the full multiplier effect to be seen, and any change to consumer confidence during this period will impact the final outcome.