2.4.4 The Multiplier

This study note for Edexcel covers the Multiplier

a) The Multiplier Ratio

Multiplier Ratio:

• The multiplier ratio 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.

Formula:

• Multiplier = 1 / (1 - MPC)
• Alternatively, Multiplier = 1 / MPW, where MPW (Marginal Propensity to Withdraw) = MPS + MPT + MPM.

b) The Multiplier Process

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.
• 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.

Real-World Example:

• If the government spends $1 billion on infrastructure, this money pays workers and suppliers, who then spend their income on various goods and services, creating additional rounds of spending.

c) 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.

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.

Real-World Example:

• During economic downturns, governments often increase spending to stimulate demand, leveraging the multiplier effect to boost growth.

d) Understanding of Marginal Propensities and Their Effects on the Multiplier

Marginal Propensity to Consume (MPC):

• The fraction of additional income that households spend on consumption.
• Higher MPC results in a larger multiplier as more income is recycled into the economy.

Marginal Propensity to Save (MPS):

• The fraction of additional income that households save.
• Higher MPS leads to a smaller multiplier as more income is withdrawn from the spending cycle.

Marginal Propensity to Tax (MPT):

• The fraction of additional income that is paid in taxes.
• Higher MPT reduces the multiplier as more income is diverted to the government.

Marginal Propensity to Import (MPM):

• The fraction of additional income spent on imports.
• Higher MPM decreases the multiplier as income leaks out of the domestic economy.

Effects on the Multiplier:

• A high MPC and low MPS, MPT, and MPM result in a larger multiplier.
• Conversely, a low MPC and high MPS, MPT, and MPM lead to a smaller multiplier.

e) Calculations of the Multiplier

Formula 1:

• Multiplier = 1 / (1 - MPC)
  • If MPC = 0.8, Multiplier = 1 / (1 - 0.8) = 5

Formula 2:

• Multiplier = 1 / MPW
  • If MPS = 0.1, MPT = 0.1, MPM = 0.1, then MPW = 0.1 + 0.1 + 0.1 = 0.3
  • Multiplier = 1 / 0.3 ≈ 3.33

f) The Significance of the Multiplier for Shifts in AD

Shifts in Aggregate Demand (AD):

• The multiplier effect means that an initial increase in AD results in a larger overall increase in national output and income.
• Example: An initial increase in government spending by $100 million can result in a total increase in GDP of $500 million if the multiplier is 5.

Policy Implications:

• Understanding the multiplier helps policymakers design effective fiscal policies to manage economic cycles.
• Stimulus Measures: Governments can use fiscal stimulus to combat recessions, knowing the multiplier effect will amplify the impact.
• Austerity Measures: Conversely, cutting spending can have a larger-than-expected negative impact due to the multiplier.

Glossary

• Aggregate Demand (AD): The total demand for goods and services within an economy at a given overall price level and in a given time period.
• Gross Domestic Product (GDP): The total value of goods produced and services provided in a country during one year.
• Marginal Propensity to Consume (MPC): The proportion of additional income that is spent on consumption.
• Marginal Propensity to Save (MPS): The proportion of additional income that is saved.
• Marginal Propensity to Tax (MPT): The proportion of additional income paid in taxes.
• Marginal Propensity to Import (MPM): The proportion of additional income spent on imports.
• Marginal Propensity to Withdraw (MPW): The sum of the marginal propensities to save, tax, and import.

Key Economists

• John Maynard Keynes: Introduced the concept of the multiplier in his work "The General Theory of Employment, Interest, and Money," emphasizing the importance of aggregate demand in determining economic output.
• Richard Kahn: Further developed the concept of the multiplier, particularly in the context of public works and their impact on employment and output.

Possible Essay-Style Questions

1. Discuss how the multiplier effect influences the effectiveness of fiscal policy in managing economic cycles.
2. Analyze the role of marginal propensities (MPC, MPS, MPT, MPM) in determining the size of the multiplier and its impact on the economy.
3. Evaluate the potential consequences of a government implementing a large-scale public works program on national income and employment, using the multiplier concept.