2.4.4 The multiplier

• The multiplier ratio

  It quantifies the total change in national income resulting from an initial change in spending.

  
  

  It demonstrates how initial spending generates further income and consumption, leading to a multiplied effect on the overall economy.
• The multiplier process

  Initial Spending: An initial increase in spending (e.g., government investment, export demand) injects money into the economy.

  
  

  Income Generation: This spending becomes income for households and firms, who then spend a portion of this income.
• The multiplier process - 2

  Secondary Spending: The subsequent spending generates additional income for others, continuing the cycle.

  
  

  Diminishing Returns: Each round of spending is smaller due to withdrawals (savings, taxes, imports), eventually tapering off.
• When does the multiplier effect occur?

  The multiplier effect occurs when an initial injection into the economy, or circular flow of income, causes a larger final increase in the level of real national income/output
• Multiplier ratio formula

  K= 1 / MPW OR K= 1 / (1-MPC)

  
  

  where K= the multiplier, MPW= the marginal propensity to withdraw, MPC= marginal propensity to consume
• What does the multiplier show?


  The multiplier shows the impact of a change in investment on national income
• What is marginal propensity to consume?

  -(MPC) is the proportion of a change in income (the margin) that will be spent on consumption rather than being saved.

  -The proportion of additional income that is spent
• What does marginal propensity to consume depend upon?

  - The marginal propensity to save (MPS):If interest rates are high, then consumption may not rise significantly as additional income may be saved rather than spent-MPS: The proportion of additional income that is saved
• What does marginal propensity to consume depend upon? (2)

  - The marginal propensity to tax (MPT): Taxes are a withdrawal from the circular flow, if tax rates are high then consumers will be deterred from spending or simply have less disposable income with which to consume goods and services-MPT: The proportion of additional income that ispaid in tax
• What does marginal propensity to consume depend upon? (3)

  The marginal propensity to import (MPM): In the UK, we have a high propensity to consume imports. If we receive increases in disposable income, but this is spent on imported goods, then this would count as a withdrawal or leakage from the circular flow of income and national income would not rise as much as anticipated-MPM: The proportion of additional income that is spent on imports
• How is the multiplier determined?

  The multiplier will be determined by the size of the leakages from the economy - MPS, MPT and MPM.
• What is the positive multiplier effect?

  When an initial increase in an injection (or a decrease in a leakage) leads to agreater final increase in real GDP
• The negative multiplier

  -Cuts in spending and increases in taxes will lead to a

  negative multiplier and a fall in GDP

  
  

  -The size of the multiplier will be dependent on the

  marginal propensity to consume (MPC).

  
  

  -If individual have a high MPC this will feed through to a

  higher value of the multiplier.

  
  

  -If individuals have a high marginal propensity to save

  (MPS) this will lead to a lower value of the multiplier
• What is the negative multiplier effect?

  When an initial decrease in an injection (or an increase in a leakage) leads to agreater final decrease in real GDP
• Factors that affect disposable income - in relation to changing the multiplier

  -If taxes increase the value of the multiplier reduces

  -If interest rates increase, savings increase and consumption decreases and the multiplier reduces

  -If exchange rates appreciate the level of imports will increase and the multiplier decreases

  -If confidence in the economy increases consumption increases and the multiplier increases
• Significance of the Multiplier in Shifting AD

  -Any increase in C + I + G + (X - M), will shift the aggregate demand curve to the right, and consequently will increase the level of real national output and the circular flow of income

  -The greater the withdrawals, the smaller the value of the multiplier - and vice versa

  -The greater the MPC, the greater the value of the multiplier - and vice versa

  -An increase in consumption immediately increases AD

  Investment + Gov spending + Exports = injectionsImports = withdrawals
• What are the changing variables that will be impacted by the multiplier

  -If there is very little spare capacity in the economy, then any increase in aggregate demand may not be able to be met by firms

  
  

  -Unemployment

  
  

  -Economic growth

  
  

  -Inflation

  
  

  -Exchange rates
• Effects of the Multiplier on the Economy

  Economic Expansion:

  The multiplier amplifies the effects of initial spending increases, leading to greater overall economic growth.

  
  

  Job Creation: Increased demand for goods and services requires more labor, reducing unemployment.

  Income Growth: Higher demand raises incomes, enhancing living standards.
• Effects of the Multiplier on the Economy - 2

  Economic Contraction:

  Conversely, a reduction in spending can have a multiplied negative impact, leading to deeper recessions.

  Increased Unemployment: Lower demand reduces the need for labor, increasing unemployment.

  
  

  Decreased Income: Reduced economic activity leads to lower incomes and consumption.