2.4.4 The Multiplier Flashcards
The multiplier ratio
The ratio of change in real income to the injection that created the change.
Explain the multiplier effect
The multiplier effect occurs when an initial injection into the circular flow causes a bigger final increase in real national income.
What idea is the multiplier process based on?
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.
What will the multiplier effect do to AD?
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).
Marginal Propensity to Consume (MPC)
The proportion of additional income that is spent.
Marginal Propensity to Save (MPS)
The proportion of additional income that is saved.
Marginal Propensity to Tax (MPT)
The proportion of additional income that is paid in tax.
Marginal Propensity to Import (MPM)
The proportion of additional income that is spend on imports.
Marginal propensity to withdrawal
MPW=MPS+MPT+MPM
what is the opposite of multiplier
De-multiplier : A de-multiplier occurs when income is withdrawn from the economy, such as when taxes, savings, or import spending increase.
The effects of Marginal Propensities on the Multiplier
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.
How can the value of the multiplier be calculated?
Give an example of how the multiplier works in an economy
Let’s say a government decides to build a new hospital at a cost of £50 billion.
Government spending (G) will rise by £50bn. AD and real GDP will rise by £50bn.
The government will spend £25bn of this money on a construction firm. The firm spends £10bn on investment (I), a component of AD. Investment rises by £10bn.
The firm also spends £5bn on workers who receive higher incomes and spend this – so now consumer spending (C) goes up by £5bn. C is another component of AD.
AD has risen £65bn (£50bn plus £10bn plus £5bn) from an initial £50bn.
So, if spending rises by an initial £50bn, there will be one large rightwards shift in AD. But each stage of the multiplier effect could be viewed to add another small rightwards shift in AD, each of a smaller size than the last.
An example of the multiplier in real life
Japelli (1990) found that 20% of the American population was credit-constrained.
Gross & Souleles (2002) found that 2/3 of people responded to automatic increases in their credit card limits by spending more.
Both these studies suggest that the MPC may be high and that the availability of credit (or debt) could be the constraining factor.
If taxes increase, what will happen to the value of the multiplier?
The multiplier reduces (because the MPT increases, meaning more money is withdrawn from the circular flow)
If interest rates increase, what will happen to the value of the multiplier?
The multiplier reduces, because interest rates cause savings to increase and consumption in the economy therefore decreases.
If exchange rates appreciate, what will happen to the value of the multiplier?
The multiplier reduces, because the level of imports will increase (which is a withdrawal from the circular flow).
If confidence in the economy increases, what will happen to the value of the multiplier?
The multiplier increases because consumption increases in the economy as condifence is higher.
Why does the IMF only lend money for infrastructure?
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!
What is the safest investment for governments?
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.
Cost-benefit analysis (CBA)
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.
Key evaluation point on the effectiveness of the multiplier effect
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.
What is a key evaluation point when it comes to talking about MPC
The point is that MPC for poorer households or people in lower income countries tends to be higher compared to richer counterparts.
