9- The Multiplier and Circular Flow of Income Flashcards
Multiplier definition
The number of times a rise in national income exceeds the rise in injections of demand that caused it.
An initial change in AD can have a much greater impact on the level of equilibrium national income.
What causes the multiplier effect?
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. This can lead a bigger eventual effect on output and employment
Positive Multiplier
When an initial increase in an injection (or a decrease in a leakage) leads to a greater final increase in real GDP.
Negative Multiplier
When an initial decrease in an injection (or an increase in a leakage) leads to a greater final decrease in real GDP.
Link between the Multiplier and Keynesian economics?
- John Maynard Keynes said in the 1930’s the multiplier was a tool to help governments maintain high levels of employment.
- This “demand-management” approach designed to help overcome a shortage of capital investment.
What determines the value of the multiplier?
- Propensity to import
- Propensity to save
- Propensity to tax
- Amount of spare capacity
- Avoid crowding out
Definition of crowding out
When government spending fails to increase overall aggregate demand because higher government spending causes an equivalent fall in private sector spending and investment.
Multiplier formulas
- K = 1 / MPW (marginal propensity to withdraw)
- K = 1 / (1-MPC) (marginal propensity to consume)
- MPC + MPW = 1
Who the government targets in times of low demand?
Increasing the income with those with a high MPC will increase overall AD.
Factors affecting the size of the multiplier?
- The higher the propensity to consume domestically produced goods. The government can influence the size of the multiplier through changes in direct taxes. E.g. cut in the rate of income tax will increase the amount of extra income that can be spent on further goods and services.
- The propensity to purchase imports. If extra income is spent on imports, money is taken away from the circular flow of income and spending, reducing the size of the multiplier.
- Sufficient spare capacity for extra output to be produced. If SRAS is inelastic, the full multiplier effect is likely to occur, because increases in AD will lead to higher prices rather than a full increase in real national output. In contrast, if SRAS is perfectly elastic a rise in AD causes a large increase in national output.
- Crowding out- where increased gov spending or lower taxes can lead to a rise in gov borrowing and/or inflation which causes interest rates to rise and his the effect of slowing down economic activity.
When will the multiplier be large?
- The propensity to spend extra income on domestic goods and services is high.
- The marginal rate of tax on extra income is low.
- The propensity to spend extra income rather than save is high.
- Consumer confidence is high (this affects willingness to spend gains in income).
- Businesses in the economy have the capacity to expand production to meet increases in demand.
Marginal propensity to consume (MPC) definition
Proportion of a change in income (the margin) that will be spent on consumption rather than being saved.
What will the marginal propensity to withdraw (MPW) depend on?
- Marginal propensity to save (MPS)
- Marginal propensity to tax (MPT)
- Marginal propensity to import (MPM)
Marginal propensity to save (MPS) definition
If interest rates are high, then consumption may not rise significantly as additional income is being saved rather than spent.
Marginal propensity to tax (MPT) definition
Taxes are a withdrawal from the circular flow of income, if tax rates are high then consumer will be deterred from spending or simply have less disposable income with which to consume goods and services.
