3. How the Macroeconomy Works - Aggregate Demand & Economic Activity Flashcards
How does the multiplier effect work?
The multiplier effect comes about because injections of new demand for goods and services into the circular flow of income stimulate further rounds of spending – in other words one person’s spending is another’s income
What are the two types of multiplier effects?
Positive Multiplier - When an initial increase in an injection results in a greater overall increase in GDPNegative Multiplier - When an initial decrease in an injection results in a greater overall decrease in GDP
Illustrate the multiplier effect using an example.
£300 million increase in capital investment – for example created when an overseas company decides to build a new production plant in the UK - Firms who produce the capital goods and construction businesses who win contracts to build the new factory will see an increase in their incomes and profits - If they and their employees in turn, collectively spend about 3/5 of that additional income, then £180m will be added to the incomes of others - At this point, total income has grown by (£300m + (0.6 x £300m) - The sum will continue to increase as the producers of the additional goods and services realize an increase in their incomes, of which they in turn spend 60% on even more goods and services - The increase in total income will then be (£300m + (0.6 x £300m) + (0.6 x £180m).Each time, the extra spending and income is a fraction of the previous addition to the circular flow.
What is marginal propensity to consume?
Marginal Propensity Consume is the likelihood of consumers in an economy to spend more money and consume goods. If you gave someone an extra £100 how much would they spend on consumption and how much would they save.
How does marginal propensity to consume influence the multiplier effect?
Logically, the multiplier effect is higher when there is a high marginal propensity to consume. The more times an initial injection is circulated the greater the multiplier effect - if firms are more likely to save (low MPtC) the initial injection will circulate fewer times, meaning the multiplier effect is less.
