1.5 The multiplier and the accelerator

Multiplier

Process by which any change in a component of AD results in a greater final change in GDP

Accelerator

The theory of investment by which the level of investment depends on the change of national income

Output gaps

The difference between actual GDP and full employment level 

If actual below full employment level= negative output gap 

If actual above full employment level= positive output gap

Production possibility curve (PPC) 

The maximum possible output an economy can achieve when fully utilising its resources

Average propensity to consume (APC)

The proportion of income households devote to consumer expenditure

Marginal propensity to consume (MPC)

The proportion of additional income devoted to consumer expenditure i.e. Marginal propensity to consume (MPC) measures how much more individuals will spend on consumption for every additional unit of income. 

Marginal propensity to withdraw (MPW)

The proportion of additional income that goes as leakages, made up of savings, tax and imports

Marginal propensity to save (MPS)

The proportion of additional income that is saved

Marginal propensity to tax (MPT)

The proportion of additional income that is taxed

Marginal propensity to import (MPM)

The proportion of additional income that is spent on imports

How does the multiplier effect come about?

Injections of new demand for goods and services into the circular flow of income stimulate further rounds of spending because “one person’s spending is another’s income”

This leads to a bigger final effect on the level of national output and also total employment in the labour market

Calculating the multiplier

Multiplier = 1 / (sum of the propensity to save + tax + import)

Positive Multiplier vs Negative Multiplier Effects

Positive multiplier: When an initial increase in an injection (or a decrease in a leakage) leads to a greater final increase in real GDP.

Negative multiplier: When an initial decrease in an injection (or an increase in a leakage) leads to a greater final decrease in real GDP.

Calculating the Marginal Propensity to Consume

MPC = change in consumption following a change in income

= change in total consumption / change in gross income

E.g. if gross income increases by £5,000 and spending rises by £4,000 then the MPC = £4,000 / £5,000 = 0.8

Calculating the Marginal propensity to save (MPS)

MPS = change in savings following a change in income

= change in total savings / change in gross income

E.g. If rise in gross income = £5,000 and rise in C = £4,000, then change in saving = £1,000. Therefore MPS = £1,000 / £5,000 = 0.2

Elasticity of Aggregate Supply & the Multiplier Effect 

High Multiplier Value when

Economy has plenty of spare capacity (negative output gap) to meet higher demand

Marginal propensity to import and tax is low

High propensity to consume any extra income (i.e. a low propensity to save)

Low Multiplier Value when

Economy is close to it’s capacity limits e.g. during a boom phase

Propensity to import goods & services is high - extra demand leaks from circular flow

Higher inflation causes rising interest rates which then dampens other components of AD

Summary of formulas

Measuring The Output Gap

The output gap is the difference between the actual level of GDP and its estimated potential level. It is usually expressed as a percentage of the level of potential output.

Negative Output Gap when

When the level of actual GDP is less than potential GDP

Some factor resources are under-utilised e.g. demand-deficient unemployment

Main problem is likely to be higher unemployment and possible deflation risk

Positive Output Gap when

Actual GDP is greater than the estimated potential GDP 

Some resources working beyond usual capacity (shift work & overtime)

Main problem is rising demand-pull and cost-push inflationary pressures

Problems in Measuring the Output Gap

We cannot observe directly the supply potential of an economy directly

Inaccurate data on the labour force for example difficulties in measuring the scale of net inward labour migration

Problems in accurately measuring productivity

Surveys of producers about spare capacity may be inaccurate

Gaps in knowledge about how much businesses are investing and the potential output from new capital e.g. in digital sectors

Uncertainties about the number of people who may have left the labour market as “discouraged workers”

Hard to measure the amount of under-employment in the labour market at different stages of the economic cycle