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
when changes in investment can be directly linked to changes in the rate of GDP growth
multiplier equation
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
Increase in Initial Injection
- When an economy receives an initial injection of spending, such as investment, government spending, or exports, it leads to further rounds of spending.
eg, if a government builds a new road, construction workers earn wages that they spend on goods and services, creating additional income for others in the economy. - This process amplifies the initial injection, leading to a greater overall increase in aggregate demand (AD). The total increase depends on the marginal propensity to consume (MPC), as higher MPCs result in stronger multiplier effects.
- The impact is a larger boost to GDP than the initial spending, fostering economic growth. However, the size of the multiplier effect depends on leakages such as savings, taxation, and imports.
Multiplier Effect: Point, Analysis, and Impact
Increase in Initial Injection
When an economy receives an initial injection of spending, such as investment, government spending, or exports, it leads to further rounds of spending.
For example, if a government builds a new road, construction workers earn wages that they spend on goods and services, creating additional income for others in the economy.
This process amplifies the initial injection, leading to a greater overall increase in aggregate demand (AD). The total increase depends on the marginal propensity to consume (MPC), as higher MPCs result in stronger multiplier effects.
The impact is a larger boost to GDP than the initial spending, fostering economic growth. However, the size of the multiplier effect depends on leakages such as savings, taxation, and imports.
Higher Consumer Spending
- A higher MPC means more of each additional dollar earned is spent, creating further rounds of consumption.
- For example, if a household receives $1,000 and spends $800 (MPC = 0.8), businesses see an increase in revenue, which they may use to pay workers or invest, perpetuating the cycle.
- This repeated spending increases AD in the short term, which can lead to higher output and employment. However, if the economy is near full capacity, this could also lead to inflationary pressures.
accelerator effect chain of analysis
Accelerator Effect: Point, Analysis, and Impact
Initial Increase in Demand
When demand for goods and services rises, businesses experience higher sales and may approach their production capacity limits.
For example, a surge in demand for electric vehicles might lead manufacturers to use their existing factories more intensively.
As firms exhaust their current capacity, they are incentivized to invest in new capital, such as machinery, factories, or technology, to meet future demand. This investment amplifies the initial increase in aggregate demand (AD).
The impact is a boost to economic growth, as investment not only raises current AD but also enhances future productive capacity (shifting LRAS right). However, the effect may be muted if businesses are uncertain about sustained demand.
Dependent on Confidence
The accelerator effect depends heavily on business confidence. Firms are more likely to invest if they believe the increase in demand will be sustained.
For example, in a period of economic uncertainty or political instability, firms may hold back on investment despite rising demand.
The impact is that the accelerator effect is less pronounced during uncertain times, potentially dampening the positive effects of rising demand on economic growth.
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
