The Multiplier How much will NI change by when there is an increase in injections?

Recall the Circular Flow of Income Injections: I, G and X Withdrawals: S, T and M

The Multiplier An initial change in AD can have a much greater final impact on the level of equilibrium NI This is because injections into the circular flow of income stimulate further rounds of spending – in other words “one person’s spending is another’s income” – and this can lead to a much bigger effect on equilibrium output and employment. The multiplier provides a measure of the magnitude of changes in GDP caused by changes in AD eg. if the multiplier is 3, an increased injection of $100m will increase Y by $300m

Very Simple Circular Flow of Income Model C Wages, rent, interest and profit I+G+X S+T+M Assume initial injection of G of $100m This goes to firms, then consumers, then firms, then consumers and so on. Each time the money is circulated some ‘leaks’ out of the flow, but still some of the additional money will be spent over and over, increasing GDP by more than $100m

Example A large firm spends an $100m extra on a new factory. Initially NI rises by $100m This will set off a chain reaction of increases in expenditures. Firms who produce the capital goods that are purchased will experience an increase in their incomes and profits If they in turn, collectively spend about 3/5 of that additional income, then £60m will be added to the incomes of others. At this point, NI has grown by $160m The sum will continue to increase as the producers of the additional goods and services realise an increase in their incomes, of which they in turn spend 60% on even more goods and services. The increase in NI will then be $196 The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow (there are withdrawals at every stage) Hence the initial injection of $100m results in NI rising by more than $100m Handout- ‘The multiplier: a numerical approach

The concept of the multiplier process became important in the 1930s when John Maynard Keynes suggested it as a tool to help governments to achieve full employment. This macroeconomic “demand-management approach”, designed to help overcome a shortage of business capital investment, measured the amount of government spending needed to reach a level of national income that would prevent unemployment.

Calculating the size of the multiplier The size of the multiplier depends on what proportion of additional disposable income is spent on domestic goods and services this is known as the marginal propensity to consume (mpc) mpc= ΔC/ ΔY d

The multiplier= 1/ 1-mpc Eg. If the mpc was 0.6 and there was an injection of $100m then the change to national income would be $100 x (1/ 1-0.6) = $100 x 1/0.4 = $100 x 2.5 =$250m

Another way… The multiplier= 1/ mps + mpt + mpm mps= marginal propensity to save mpt= marginal propensity to tax mpm= marginal propensity to import Note: mpc + mps + mpt + mpm = 1 The smaller the value of the withdrawals the larger the value of the multiplier So changes to withdrawals (eg. change in tax rates) change the value of the multiplier

Activity Multiplier Worksheet

The multiplier process also requires that there is sufficient spare capacity in the economy for extra output to be produced. If short-run aggregate supply is inelastic, the full multiplier effect is unlikely to occur, because increases in AD will lead to higher prices rather than a full increase in real national output. In contrast, when SRAS is perfectly elastic a rise in aggregate demand causes a large increase in national output.

What are the two things to keep in mind when government plans to intervene to fill a deflationary gap? It must estimate the gap between the equilibrium output and full employment output. It must estimate the value of the multiplier so it can judge the suitable increase in AD that is necessary to inject into the economy in order to fill the gap.

The government needs to consider… The higher the withdrawals (taxes, imports and savings), the lower the multiplicative effect of any given increase in government spending. Lower interest rates will lower the MPS, Lower income taxes will lower the MRT Barriers to trade will lower the MPM. All will lower the MPW and thus increase the value of the multiplier.

Recall- The Multiplier 1.Calculate the multiplier for an economy where the mpc is By how much will national income increase in total if there is an investment of $50,000. Answer: Multiplier is 4. 1/0.25=4 National income increases by $200,000 (4*$50,000)