Chapter 21 - The multiplier and the accelerator Flashcards
What is a multiplier?
The ratio of a change in real income to the autonomous change that brought it about.
How does the multiplier work?
In his General Theory, Keynes pointed out that there may be multiplier effects in response to certain types of expenditure. Suppose that the government increases its expenditure by £1 billion, perhaps by increasing its road-building programme. The effect of this is to generate incomes for households for example, those of the contractors hired to build the road. Those contractors then spend part of the additional income (and save part of it). By spending part of the extra money earned, an additional income stream is generated for shopkeepers and café owners, who in turn spend part of their additional income, and so on. Therefore, the original increase in government spending sparks off further income generation and spending, causing the multiplier effect. In effect, equilibrium output may change by more than the original increase in expenditure.
What does the size of the multiplier effect depend on?
How much of the additional income is:
- saved by households
- spent on imported goods
- returned to the government in the form of indirect taxes.
What is the average propensity to save?
The proportion of income that households devote to consumer expenditure
What is marginal propensity to consume (mpc)?
The proportion of additional income devoted to consumer expenditure
What is marginal propensity to save (mpc)?
The proportion of additional income that is saved by households
How do we calculate the average and marginal propensity to consume?
Suppose that in an economy, household consumption (C) is £80 and disposable income (Y) is £100. The average propensity to consume is calculated as C/Y = 80/100 = 0.8. If disposable income increases to 110 and consumption rises to 87, we can calculate the marginal propensity to consume as the proportion of the increase in income that is devoted to consumption. We need to divide the change in consumption by the change in income. In other words, it is (87-80)/(110 - 100) = 0.7.
What is the marginal propensity to import (mpm)?
The proportion of additional income that is spent on imports and good and services.
What is the marginal propensity to tax (mpt)?
The proportion of additional income that is taxed
What is the marginal propensity to withdraw (mpw)?
The proportion of additional income that is withdrawn from the circular flow - the sum of the marginal propensities to save, import and tax.
How do we calculate mpw and mpc?
mpw = mps + mpt + mpm
mpc = 1 - mpw
How do we calculate the multiplier?
A numerical value for the multiplier can be calculated with reference to the withdrawals from the circular flow. Suppose that the mps is 0.25, the mpm is 0.1 and the mpt is 0.15. The mpw is then 0.25 + 0.1 +0.15 = 0.5. The multiplier formula is 1 divided by the marginal propensity to withdraw (1/mpw). If the mpw is 0.5, then the value of the multiplier is 2, so for every £100 million injection into the circular flow, there will be a £200 million increase in equilibrium output.
How does injections and leakages affect the multiplier?
The important element in considering the multiplier is the role played by injections and leakages, which appeared in the circular flow model. The multiplier effects that Keynes discussed are triggered by injections into the circular flow, whereas the size of the multiplier effects is determined by the leakages.
The injections into the circular flow come in the form of government expenditure, investment and exports. The fact that injections can have a multiplied effect on equilibrium output and income seems to make the government potentially very powerful, as by increasing its expenditure it can have a multiplied effect on the economy’s output and income.
It is worth noting that the size of the leakages may depend in part upon whether or not firms are able to increase output. If domestic supply is inflexible, and therefore unable to meet an increase in demand, more of the increase in income will spill over into purchasing imports, and this will dilute the multiplier effect.
How is the AD/AS diagram affected by the existence of the multiplier?
In terms of the AD/AS diagram, the existence of the multiplier means that if there is an increase in injection (e.g. investment or government spending), the AD curve moves further to the right than it otherwise would’ve done, because of the multiplier effects.
What is the accelerator?
A theory by which the level of investment depends upon the change in real output.
How does the accelerator work?
The idea of the multiplier is based on the induced effects of expenditure that spread the initial effects of an increase in spending. A similar notion is that of the accelerator. The notion of the accelerator arises from one of the driving forces behind firms’ investment. Some investment is needed for depreciation (i.e. replacement for old or outdated equipment and to allow for wear and tear). However, most investment is needed for when firms wish to expand capacity. If there is an increase in demand for a firm’s product (or if a firm expects there to be an increase in demand), it may need to expand capacity in order to meet the increased demand. This suggests that one of the determinants of the level of investment is a change in expected demand. Notice that it is the change in demand that is important, rather than the level, and it is this that leads to the notion of the accelerator. In other words, if a firm sees a significant expansion in demand for its product, this can initiate the accelerator if the firm expects this change to signal more increases in the future.
Suppose that the economy is below full employment and begins to recover. As the recovery begins, demand begins to increase, and firms undertake investment in order to expand capacity. In other words, the accelerator effect cuts in, as firms observe the change in demand and need more capital to meet expected future demand. However, as the economy approaches full capacity, the growth rate slows down — and hence investment falls, as it reacts to the change in output. This occurs because the accelerator goes into reverse.
The multiplier and accelerator interact with each other. If there is an increase in output following an increase in aggregate demand, the accelerator induces an increase in investment. The increase in investment then has a multiplier effect that induces an additional increase in demand.
In this way, the multiplier and accelerator reinforce each other. The downside to this is that the same thing happens when output slows, as this leads to a fall in investment, which has negative multiplier effects.
This interaction between the multiplier and the accelerator can result in cyclical fluctuations in the level of output.
How does AS affect the accelerator?
As firms increase investment expenditure, the productive capacity of the economy increases. This means that there is an increase in the full employment level of real GDP. In other words, the long-run aggregate supply curve shifts to the right.
If the economy settles at the new full employment level of real GDP, firms may cease to expect further increases in demand and reduce their investment expenditure, which would then put the accelerator process into reverse.
What is an output gap?
The difference between the actual level of real GDP and the full employment level
What are the causes and consequences of an output gap?
We have seen that the macroeconomy may be subject to external shocks that may take it away from its equilibrium position, so at any point in time real GDP may deviate from the full employment level, either above or below. The difference between actual GDP and the full employment level is known as the output gap.
At any point in time, real GDP can be above or below the full employment level, so the output gap can be positive or negative. When real GDP is above the full employment level (as it can be before it readjusts), the output gap is positive. If real GDP is below the full employment level, the output gap is negative.
A positive output gap may occur if there is an increase in aggregate demand when the economy is already at full employment, perhaps because of an increase in government expenditure or export demand.
In the short run, GDP can rise above the full employment rate, with a movement up along the short-run aggregate supply curve, possibly reinforced by multiplier effects. Firms will be prepared to supply more output in the short run in response to the increase in demand, by using factor inputs more intensively. However, this will be unsustainable in the longer run, as prices begin to rise and firms face higher input costs. The consequence is therefore that there will be upward pressure on the price level, but little if any effect on real GDP in the long term.
A negative output gap arises when real GDP falls below the full employment level. This could occur if there is a negative external shock to aggregate demand, for example if there is a global slowdown that results in a fall in the demand for exports, or if the government decides to cut back on expenditure. The consequences of this depend on whether the decrease in aggregate demand is permanent or temporary, and whether the economy faces a neoclassical or a Keynesian long-run aggregate supply curve.
The consequences of a negative output gap are potentially more significant under Keynesian assumptions about aggregate supply, as compared with the neoclassical view. If, under neoclassical assumptions, the long-run aggregate supply curve is vertical, then the economy will return to equilibrium, although how rapidly is open to debate.
What is the evaluation of output gap?
Fluctuations in aggregate demand can give rise to an output gap, which may be positive or negative. Under neoclassical assumptions, the economy returns rapidly to its full-employment equilibrium. This suggests that an output gap would only be evident in the short run. Such fluctuations do arise, sometimes on a regular cycle.
Any of the components of aggregate demand (AD) can be the source of an increase in AD. For example, it could be that the government increases its expenditure because it believes that unemployment is higher than it should be, or perhaps firms have high expectations for the future and decide to increase their investment spending.
If the economy is subjected to an increase in AD when it is at full employment, then real GDP can move beyond the full employment level, but only during the adjustment period. This may have beneficial effects on real GDP in the short run, but the question is whether those short-run gains are sufficient to offset the long-run increase in the price level that is a consequence of the increase in AD. If the increase is repeated in subsequent periods, the consequences will be more severe, as this will result in demand-pull inflation.
The causes and consequences of a decrease in AD are of especial importance for the economy. Again, any of the components of aggregate demand can be a source of a decrease in AD. For example, if firms form pessimistic expectations about the future demand for their products, they may decide to reduce their investment spending. There are many factors that could give rise to such a change, such as the uncertainty during the Brexit negotiations, or the trade war initiated by President Trump.
The consequences of such a fall in AD depend crucially on whether the economy is facing a neoclassical or a Keynesian long-run aggregate supply
(LRAS) curve. Neoclassical economists would argue that there are forces in the economy that would carry the economy back to full employment — possibly quite rapidly. However, with a Keynesian LRAS, the economy could settle at an equilibrium that is below full employment. This will occur if the intersection with AD comes in the upward-sloping segment of the Keynesian LRAS curve. The resulting negative output gap could then persist, with consequences for long-lasting high unemployment.
The impact of a decrease in AD depends crucially on whether the change is temporary or permanent, and on the shape of the LRAS curve and the speed with which the economy is able to adjust back to long-run equilibrium.
