The Multiplier

Question 1

Multiplier effect

Answer 1

Occurs when an initial injection into the circular flow causes a greater final output in real national income (growth)

• an initial change in spending whether its from consumers, businesses, or the government leads to a larger and more widespread final impact on an economy’s total output

Question 2

Illustrates how…

Answer 2

Changes in spending can create a ripple effect throughout the economy, generating additional rounds of economic activity

Question 3

Example (individual increases spending)

Answer 3

• When an individual increases there spending, the recipients of that spending then have more income, which they, in turn, spend on goods and services.
• This creates additional demand, which prompts businesses to increase production and hire more workers, resulting in higher factor incomes

Question 4

Positive multiplier effect

Answer 4

When an initial increase in injection (or a decrease in a leakage) leads to a greater final increase in the level of GDP

Question 5

Negative multiplier effect

Answer 5

When an in initial decrease in an injection (or an increase in a withdrawal) leads to a greater final decrease in the level of GDP

Question 6

Withdrawals

Answer 6

• Savings
• Tax
• Imports

Question 7

Injections

Answer 7

• Exports
• Government spending
• Investment

Question 8

Multiplier formula

Answer 8

Multiplier = 1 / marginal propensity to save (MPS)
- The marginal propensity to consume + save must = 1
- Disposable income can be spent or saved
- MPC + MPS = 1 , therefore MPS = 1-MPC

= Multiplier = 1/ (1 - MPC)

Question 9

Multiplier formula example

Answer 9

In a closed economy with no government sector, the marginal propensity to save rises to 0.4. What is the new value of the multiplier?

• The multiplier = 1/MPS
• 1/0.4 = 2.5
• A rise in the MPS causes the value of the multiplier to fall

Question 10

Example - re-arranging using MPC

Answer 10

Question 11

Multiplier formular (extended) example

Answer 11

Question 12

Multiplier formula (extended) - open economy

Answer 12

Multiplier = 1 / MPS + MPM + MRT

In an open economy with a government sector, there are three withdrawals from the circular flow

1. Savings (marginal prospensity to save)
2. Imports (marginal prospensity to import)
3. Taxation (marginal tax rate on income)

Question 13

MPC

Answer 13

The change in consumption following a small change to income

= change in total consumption / change in income

• If income increases by $5,000 and spending rises by $4,000 then the MPC = 4,000/5,000 = 0.8

Question 14

MPS

Answer 14

The change in savings following a small change in income

= change in total savings / change in income

• If rise in income = $5,000 and rise in C=4,000 then change in saving =$1,000
• Therefore, MPS = $1,000 / $5,000 = 0.2

Question 15

What factors effect the multiplier value?

Answer 15

1. MPC
2. Leakages
3. Degree of spare capacity
4. Time frame

Question 16

MPC - affect on multiplier value

Answer 16

A higher MPC leads to a larger multiplier effect
because a greater proportion of any initial increase in income is spent, leading to multiple rounds of increased spending and output.

Question 17

Leakages - affect on multiplier value

Answer 17

Leakages from the circular flow, such as saving, taxes, and imports, reduce the size of the multiplier. If people save a significant portion of their additional income, or if a substantial portion of the increased spending leaks out of the economy in the form of taxes or imports, the multiplier effect will be smaller.

Question 18

Degree of spare capacity - affect on multiplier value

Answer 18

If an economy is operating close to its full potential (with little spare capacity), the multiplier effect might be limited.

Question 19

Time frame - affect on the multiplier value

Answer 19

In the short run, factors like capacity constraints and rigidities in adjusting production can limit the multiplier’s size. In the long run, adjustments in production capacity, investments, and resource allocation can lead to a larger multiplier effect.

Question 20

High Multiplier value >1

Answer 20

• Economy has plenty of spare capacity (a negative output gap) to meet higher aggregate demand
• Marginal propensity to import and tax is low (import leakages)
• High propensity to consume any extra income (people have a low marginal propensity to save)

Question 21

Low multiplier value when

Answer 21

• Economy is close to capacity limits during a boom phase of an economic cycle
• Propensity to import goods and services is high - this means extra demand leaks from circular flow
• Higher inflation causes rising interest rates which then dampens the other components of AD

Question 22

Multiplier and elasticity of aggregate supply

Answer 22

Question 23

Multiplier

Answer 23

Investment leads to growth