Economic Issues: An Introduction DE3A 34 Outcome 2 Topic 10 Multiplier Effect

The Multiplier  The multiplier is concerned with how national income changes as a result of a change in an injection, for example investment.  The multiplier was a concept developed by John Maynard Keynes (pictured) that said that any increase in injections into the economy (investment, government expenditure or exports) would lead to a proportionally bigger increase in National Income.

But Why?  This is because the extra spending would have knock-on effects creating in turn even greater spending.  The size of the multiplier would depend on the level of leakages.  It can be measured by the formula 1/(1-MPC) where the MPC is the marginal propensity to consume.marginal propensity to consume Consider the following!

The Multiplier HOUSEHOLDS FIRMS Factor Incomes (£100m) Consumption (£75m) Investment (£25m) Saving (£25m) Income= £100m Consumption= £75m Savings= £25m Investment= £25m Savings = Investment

The Multiplier  The economy previous was in equilibrium.  Suppose there is now an increase in investment of £20m.  The immediate effect is to raise incomes by £20m but those who receive this income will spend a proportion of it and save a proportion.

The Multiplier  Suppose they spend ¾ of the income and save ¼.  Their Marginal Propensity to Consume is ¾, this means that £15m is spent and will become income to others (£5m will be saved).  Incomes have therefore increased not only by the original £20m increase in investment, but by a further £15m due to the extra spending.

The Multiplier  Nor is this the end of the matter – those who receive the extra £15m in incomes will again spend ¾ of the £15m and save ¼ i.e.¾ of £15m will be spent and become income to others.  ¾ of this figure will be spent and become income to others and so the process continues. Income will raise by a smaller amount at each round as follows:  £20m + (¾ x £20m) + (¾ x ¾ £20m) + (¾ x ¾ x ¾ x £20m)………….etc.

The Multiplier  The process only stops when incomes have gone up sufficiently for people to have increased their savings by the same amount as the original increase in investment thus restoring the equilibrium situation where investments = savings.  The multiplier co-efficient usually denoted by k can be calculated by the formula k = 1 1-MPC

The Multiplier  The total increase in income equals k times the increase in investment (injection).  In this example the value of the multiplier (k) = 1= 4 1-¾  The total extra savings = £20m (same as the increase in investment and equal to ¼ of the extra income)  The new equilibrium situation is therefore:

The Multiplier HOUSEHOLDS FIRMS Factor Incomes (£180m) Consumption (£135m) Investment (£45m) Saving (£45m)

The Multiplier  Adding the Government and International Trade sector, we can see that any increase in spending will have a multiplier effect: an increase in government spending or an increase in exports.  Similarly some of the increased spending will be spent on imports or taken by the government in the form of taxes i.e. it will leak out of the circular flow.

The Multiplier  Note that MPC + MPS + MPT + MPM = 1 Where:  MPT is the Marginal Propensity to Tax  MPM is the Marginal Propensity to Import  From this we can see that MPS + MPT + MPM = 1- MPC  The multiplier can therefore be expressed either as k = 1 1-MPC OR MPS + MPT + MPM

The Multiplier  Verify this from, the following figures: MPC = 0.6 MPS = 0.2 MPT = 0.1 MPM = 0.1  i.e. use both formulae to obtain the value of the multiplier – it should be the same in both cases.  The equilibrium condition for national income is injections = withdrawals, when we have government and foreign trade ( as opposed to savings = investments when we assumed no government or foreign trade).

Example 1  Assume that Y = £800m and J = W before change in J occurs.  Increase in Injections of £50m  MPC = 0.6  Find: 1. The value of the multiplier (K) and, 2. New level of (Y)

Answers 1 The multiplier K =  1/MPS or 1/1-MPC  Therefore K = 1/0.4 = 2.5 The increase in income equals K x the increase in injections  = 2.5 x £50m=£125m  Therefore the new level of Y =  Original Level of Y + the increase in incomes  = £800m + £125m  = £925m

Example 2  Assume that Y = £800m and J = W before change in J occurs.  Increase in Injections of £30m  MPC = 0.9  Find: 1. The value of the multiplier (K) and, 2. New level of (Y)

Answer 2 The multiplier K =  1/MPS or 1/1-MPC  Therefore K = 1/0.1 = 10  The increase in income equals K x the Increase in injections  = 10 x £30 =£300m Therefore the new level of Y = Original Level of Y + the increase in incomes  = £800m + £300m  = £1100m

The Multiplier based on MPC = 0.9 and MPS = 0.1 Rise in Injections Rise in Income Rise in Consumpt ion Rise in Savings £100m £90m£10m £90m£81m£9m £81m£72.9m£8.1m £72.9mAnd on and on………….

The Multiplier based on MPC = 0.8 and MPS = 0.2 Rise in Injections Rise in Income Rise in Consumpt ion Rise in Savings £100m £80m£20m £80m£64m£16m £64m£51.2m£12.8m £51.2mAnd on and on………….

Exercises Find 1. The value of the multiplier 2. The total income generated 3. The total extra leakages In the following situations: 1. Increase in investment of £100m MPC = 4/5 2. Increase in investment of £200m MPC = 2/3 3. Increase in Government spending of £50m MPC = 9/10 4. Increase in Government spending of £60m MPC = ¾ 5. Increase in exports of £100m MPS = 0.2, MPT = 0.1, MPM = 0.1

Importance of the multiplier  The Government may input income into the model (spend) to stimulate demand for goods and services creating jobs to make goods and services to satisfy demand.  Inflation may rise due to the higher demand for goods and services, raising prices.  Conversely, the Government may withdraw money from the flow of income reducing demand and reducing prices. This may cause production to be reduced causing unemployment in our firms.

Importance of the multiplier  The multiplier helps us to gauge the effect of Fiscal (Budgetary) policy on the flow of income, levels of economic growth.  The Government can control G and T, they do not have direct control over changes in M, S, X and I.  The time lag in implementing policy and the effect of that policy change may be long enough to compound problems rather than solve issues.

The Multiplier  Further Reading  An application of the multiplier An application of the multiplier  In the News In the News  Revision Notes  tutor2u tutor2u  Circular Flow of Income Circular Flow of Income  The National Income Accounts: Measuring the Circular Flow of Income: The National Income Accounts: Measuring the Circular Flow of Income:  The Multiplier Principle The Multiplier Principle