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AS Macroeconomics / International Economy

Multiplier and Accelerator Effects

In this chapter we look at two ideas, the multiplier and the accelerator, both of which help to explain how we move from one stage of an economic cycle to another

The multiplier process

An initial change in aggregate demand can have a much greater final impact on the level of equilibrium national income. This is commonly known as the multiplier effect and it comes about because injections of demand 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.

Consider a £300 million increase in business capital investment – for example created when an overseas company decides to build a new production plant in the UK. 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 £180m will be added to the incomes of others.

At this point, total income has grown by (£300m + (0.6 x £300m).

The sum will continue to increase as the producers of the additional goods and services realize an increase in their incomes, of which they in turn spend 60% on even more goods and services.

The increase in total income will then be (£300m + (0.6 x £300m) + (0.6 x £180m).

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.

Multiplier effects can be seen when new investment and jobs are attracted into a particular town, city or region. The final increase in output and employment can be far greater than the initial injection of demand because of the inter-relationships within the circular flow.

The Multiplier and Keynesian Economics

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.

The higher is the propensity to consume domestically produced goods and services, the greater is the multiplier effect. The government can influence the size of the multiplier through changes in direct taxes. For example, a cut in the basic rate of income tax will increase the amount of extra income that can be spent on further goods and services.

Another factor affecting the size of the multiplier effect is the propensity to purchase imports. If, out of extra income, people spend money on imports, this demand is not passed on in the form of extra spending on domestically produced output. It leaks away from the circular flow of income and spending.

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.

The construction boom and multiplier effects

A study has found that the British construction sector alone has driven a fifth of UK GDP growth in the past year and 34% of net job creation in the past two years. The construction boom has been caused by the combination of large projects like Terminal 5, the Channel Tunnel Rail Link, Wembley Stadium and the Scottish Parliament with a revival in house building, heavy expenditure by the public sector on new schools and hospitals and a surge in home improvement expenditure.

The study provides compelling evidence on the multiplier effects of major capital investment projects. 'One characteristic of construction activity is that it feeds through to many other related businesses. It has "backward linkages" into the likes of building materials; steel, architectural services, legal services and insurance, and most of these linkages tend to result in jobs close to home. This makes a boom in construction peculiarly powerful in fuelling expansion in the economy - for a given lift in building orders, the multiplier effect may be well over two. This means that every building job created will generate at least two others in related areas and in downstream activities such as retailing, which benefits when building workers spend their wages. Other industries, particularly those where much of the output value comes in the form of imported components, might have a multiplier of less than 1.5 for new projects'.

Adapted from a report from the Centre for Economics and Business Research

The accelerator effect

Planned capital investment by private sector businesses is linked to the growth of demand for goods and services. When consumer or export demand is rising strongly, businesses may increase investment to expand their production capacity and meet the extra demand. This process is known as the accelerator effect. But the accelerator effect can work in the other direction! A slowdown in consumer demand can create excess capacity and may lead to a fall in planned investment demand.

A good example of this in recent years is the telecommunications industry. Capital investment in this sector surged to record highs in the second half of the 1990s, driven by a fast pace of technological advance and huge increases in the ICT budgets of corporations, small-to-medium sized businesses, and extra capital investment by the public sector (including education and health).

The telecommunications industry invested giant sums in building bigger and faster networks, but demand has slowed in the first three of the decade, leaving the industry with a vast amount of spare capacity (an under-utilisation of resources). Capital investment spending in the telecommunications industry has fallen sharply in the last three years – the accelerator mechanism working in reverse.