L7 Multiplier Effect

Question 1

What is the multiplier effect?

Answer 1

Injections into the circular flow of income eventually lead to an even bigger increase in national income. This theory was originated by Keynes

Question 2

What is the multiplier determined by?

Answer 2

It is determined by the size of the withdrawals from the circular flow. The larger, the withdrawals are the lower, the multiplier will be

Question 3

What is the formula for the marginal propensity to save (define it)?

Answer 3

This is the proportion of extra income that will be saved

MPS = change is savings/ change in income

Question 4

Keep the formula and definition for marginal propensity to consume

Answer 4

MPC: the proportion of extra income that will be spent on goods and services

MPC = change in consumption / change in income

Question 5

What is the relationship between marginal propensity to consume and marginal propensity to save

Answer 5

They should add up to 1

Question 6

Define and give the formula of marginal propensity to tax

Answer 6

This is the proportion of any new income that is paid as taxes

MPT = change in taxation / change in income

Question 7

What is the formula for the marginal propensity to import

Answer 7

MPI = change in spending on imports / change in income

Question 8

Define and give the formula for the marginal propensity to withdraw

Answer 8

This is the proportion of extra income that will be withdrawn from the economy

MPW = MPS + MPM + MPT

Question 9

What is the multiplier formula?

Answer 9

1 / marginal propensity to withdraw

Question 10

How does the size of the multiplier impact shifts in AD?
Why?

Answer 10

• the larger the multiplier is the larger the increases in national income cause by injections will be.
• this is because injections trigger secondary increases in income
• larger multiplier = larger impact of AD

Question 11

What are the effects of an increase in AD

Answer 11

• higher output: faster economic growth
• higher employment: due to an increase in the demand for labour as firms will need to produce additional goods/services demanded
• higher inflation: if the economy is not in a recession

Question 12

What economic factors impact the multiplier?

Answer 12

• the level of spare capacity may limit or support the effect of the multiplier. If there’s a large spare capacity multiplier value is high. If the spare capacity is low then the multiplier is low.
• marginal propensity to import/export. When MPimport is high then multiplier value is low as demand leaks. If MPimport is low (and tax is low) then multiplier value is high
• if there is a high propensity to consume extra income the multiplier value is large
• if there is high inflation causing rising interest rates this can dampen other components of AD and this will result in a low multiplier.
• another factor other than income could be an improvement in the quality of imported goods. This would encourage importing and lower the value of the multiplier.

Question 13

What is the multiplier effect?
Briefly explain it

Answer 13

• a change in a component of AD can result in a multiplied final change in the equilibrium level of GDP
• injections of new demand for goods/services stimulates further rounds of spending
• leading to a bigger impact on real national output and total employment