Multiplier and acceleration effect Flashcards
what is the multiplier effect
an initial increase in spending leads to a greater overall increase in national income. This happens because the initial spending generates income for others, who then spend a portion of that income, further boosting national income.
what is the acceleration effect
happens when an increase in national income (GDP) results in a proportionately larger rise in capital investment spending.
In other words, we often see a surge in capital spending by businesses when an economy is growing quite strongly.
multiplier equation (extended)
1/1-MPC (marginal propensity to consume)
what determines the size of the multiplier
the MPC, bigger mpc, bigger multiplier
factors affecting MPC
Income Levels
- At lower income levels, individuals tend to have a higher MPC because basic needs consume a larger portion of income.
- As income increases, the MPC usually decreases since higher earners are more likely to save additional income.
- For example, a low-income household might spend almost all of a $100 pay raise on necessities, while a wealthy household saves a significant portion.
Wealth Effect
- Individuals with higher wealth might have a lower MPC, as they are less reliant on their income for consumption.
- Conversely, people with limited assets are more likely to consume rather than save a- ny additional income.
- For instance, during a housing market boom, homeowners might feel wealthier and increase consumption, raising their effective MPC.
Consumer Confidence
- High levels of consumer confidence encourage spending, increasing the MPC, while uncertainty about the economy leads to more savings and a lower MPC.
- For example, during periods of economic stability, households are more likely to spend bonuses, whereas in recessions, they save more.
Access to Credit
- When credit is readily available, individuals are more likely to borrow against future income, raising the MPC.
If credit access is limited, individuals may feel constrained, leading to a lower MPC.
- For example, lower interest rates can make borrowing cheaper, prompting higher spending out of additional income.
Tax Policies
- Higher taxes reduce disposable income, potentially lowering MPC, as individuals have less to spend from each additional dollar of income.
- Conversely, tax cuts increase disposable income and can raise MPC, especially for lower-income households.
Subsidies and Welfare Systems
- Generous welfare systems can provide a safety net, leading to a higher MPC since people feel more secure about their financial future.
- For example, in countries with strong unemployment benefits, people might be less inclined to save additional income and spend more.
Future Expectations
- If individuals expect their future income to rise, they are more likely to spend additional income now, increasing MPC.
- However, if they fear job losses or economic downturns, they save more, lowering the MPC.
For instance, during times of inflation uncertainty, households may save in anticipation of higher future costs.
multiplier effect chain of analysis
🔁 Multiplier Effect - How it works
➡️ An initial injection into the circular flow (e.g. government spending or investment)
➡️ Increases income for workers/businesses, who then spend a portion of it
➡️ This spending becomes income for others, leading to further rounds of consumption
➡️ Total increase in GDP is larger than the initial injection (multiplier > 1)
📈 Why the multiplier effect increases GDP
➡️ An increase in spending raises demand for goods/services
➡️ Firms respond by increasing output and hiring more workers
➡️ Workers have higher incomes → consumption increases again
➡️ This cycle continues, amplifying the overall rise in national income
📊 What affects the size of the multiplier?
➡️ The higher the marginal propensity to consume (MPC)
➡️ The lower the leakages (e.g. saving, imports, taxation)
➡️ The more responsive supply is to increased demand
➡️ The larger the eventual impact on real output
⚠️ Potential downside of multiplier effect
➡️ If economy is near full capacity, output can’t keep rising
➡️ Further demand increases → demand-pull inflation instead
➡️ Worsens current account due to increased imports
➡️ Multiplier may lead to inflation rather than real growth
accelerator effect chain of analysis
📈 Accelerator Effect – How it works
➡️ An increase in national income/output (GDP)
➡️ Leads to higher demand for goods and services
➡️ Firms may reach full capacity and need to invest in more capital (e.g., machinery, factories) to meet this new demand
➡️ This causes a disproportionate rise in investment compared to the initial change in GDP — this is the accelerator effect
🔁 Reinforcing growth cycle
➡️ More investment →
➡️ Further increases in aggregate demand (AD) →
➡️ Higher GDP and employment →
➡️ Encourages even more investment, creating a positive feedback loop
⚠️ Downturn danger – Reverse accelerator
➡️ If GDP growth slows or contracts →
➡️ Firms see less need to invest in new capital
➡️ Investment drops sharply, potentially making a recession worse
➡️ This amplifies the economic downturn
what is a negative output gap
when actual output is lower than potential output
features of a negative output gap
- underutilised resources
- low inflationary pressures
- lots of spare capacity
- reduced tax revenue
features of a positive output gap
occurs when an economy is producing above its potential output
- overutilised resources
- high inflationary pressures
- production bottlenecks
- wage pressures
negative output gap ev points
Long-Term Impacts on Potential GDP
- Prolonged underutilization of resources can lead to skill erosion and reduced labor market participation, permanently lowering potential GDP.
- For example, workers who remain unemployed for extended periods may become discouraged and leave the workforce altogether.
Deflationary Risks
- While low inflation can be beneficial, prolonged deflation can discourage spending and investment, exacerbating the downturn.
- If consumers anticipate falling prices, they may delay purchases, reducing aggregate demand further.
Policy Responses May Be Insufficient
Monetary or fiscal policy aimed at stimulating the economy may face time lags or limited effectiveness.
For instance, interest rate cuts may not boost demand if confidence remains low.
Global Context Matters
- A negative output gap might not be as harmful if other countries are also experiencing weak demand, as competitive pressures are reduced.
- For example, during global downturns, a country’s exports may face less competition despite low domestic demand.
positive output gap ev points
Sustainability of Growth
- An economy operating above its potential is not sustainable in the long term and may lead to overheating.
- For instance, excessive demand can result in inflationary spirals, reducing purchasing power.
Trade-Offs Between Growth and Stability
- While a positive output gap indicates strong economic performance, the associated inflation can erode competitiveness in global markets.
- High inflation may make exports less attractive, worsening the trade balance.
Role of Supply-Side Constraints
- If a positive output gap is driven by temporary demand shocks rather than long-term productivity improvements, it is unlikely to be sustainable.
- For example, supply bottlenecks in energy markets could limit the ability to maintain high output levels.
Policy Risks
- Attempts to cool down an overheating economy, such as raising interest rates, can slow growth too much and cause a hard landing.
- For instance, rapid monetary tightening might lead to a sharp decline in investment and consumer spending.
How do marginal propensities affect the multiplier?
Marginal propensity to consume (MPC): The proportion of additional income spent on consumption. A higher MPC leads to a larger multiplier because more of the income is spent.
Marginal propensity to save (MPS): The proportion of additional income saved. A higher MPS reduces the multiplier as less money circulates in the economy.
Marginal propensity to tax (MPT): The proportion of additional income taxed by the government. A higher MPT reduces the multiplier because more money is withdrawn from the economy.
Marginal propensity to import (MPM): The proportion of additional income spent on imports. A higher MPM reduces the multiplier because spending on imports leaks money out of the economy.
example of multiplier effect
For example, if a government spent on road construction, money will go to builders in wages. These builders spend some additional income on for example clothes, and also save some. The clothes seller earns more money, and spends some of this. The effect goes on
Infrastructure Investment 🏗️
- Government or private sector investments in large infrastructure projects can generate widespread economic activity.
Example: The Crossrail project in London (now known as the Elizabeth Line) involved large-scale infrastructure investment that generated employment in construction and related industries.
- Workers employed on the project spend their wages, stimulating demand for goods and services in local economies. Additionally, the improved transport network increases productivity, making businesses more efficient, contributing to further economic growth.
how to calculate the simple multiplier - a change in MPS
1/MPS
closed economy and their multipliers
in a closed economy with no govt spending and trade, the multiplier shows the impact of a change in investment on national income.
theres only one leakage which is savings, so the simple multiplier would be used to find the multiplier
