The Multiplier Flashcards
The multiplier ratio
This is the ratio of the rise in national income to the initial rise in AD. In other words, it is the number of times a rise in national income is larger than the rise in the initial injection of AD, which led to the rise in national income.
The multiplier process
-The multiplier effect occurs when there is new demand in an economy. This leads to an injection of more income into the circular flow of income, which leads to economic growth. This leads to more jobs being created, higher average incomes, more spending, and eventually, more income is created.
-The multiplier effect refers to how an initial increase in AD leads to an even bigger increase in national income.
-It occurs since ‘one persons spending is another persons income’
Marginal propensity to consume (MPC)
A consumers MPC is the proportion of each additional pound of household income that is spent. The higher the MPC, the bigger the size of the multiplier. The government could influence the MPC by changing the rate of direct tax. If consumers have more disposable income due to lower tax rates, their propensity to consume might increase.
Marginal propensity to save (MPS)
A consumers MPS plus the MPC is equal to 1. If consumers save more than they spend, the size of the multiplier will be small.
Marginal propensity to tax (MPT)
This is defined as the proportion of each pound taxed by the government. The higher the rate of tax, the less disposable income each consumer has, and the smaller the size of the multiplier.
Marginal propensity to import (MPM)
If consumers spend income on imports rather than domestic goods and services, income is withdrawn from the circular flow of income. This reduces the size of the multiplier.
Calculating the multiplier
-One formula that can be used is 1/(1-MPC)
-An open economy has three areas of withdrawals:taxes, imports and savings. The marginal propensity to withdraw is calculated by MPW=MPS+MPT+MPM
-This gives another formula for calculating the multiplier
1/MPW
The significance of the multiplier to shifts in AD
-If an economy has a lot of spare capacity, extra output can be produced quickly and at little extra cost. This makes AS elastic and it means the size of the multiplier will be larger. A small increase in AD will lead to a large increase in national income. This is perhaps best shown on the Keynesian curve. The vertical section is perfectly inelastic, with no spare capacity, whilst the horizontal section is perfectly elastic, with lots of spare capacity.
-If AS is inelastic, the multiplier effect is likely to be smaller than its potential. This is because if AD increases, prices will increase. The increase in output will not be as significant.
-It is possible to have a ‘reverse’ multiplier. This means that withdrawal of income from the circular flow of income could lead to an even larger decrease in income for the economy. This could decrease economic growth and potentially lead to a decline in the economy.
