Accelerator and multiplier effect

What is the accelerator effect?

When an increase in national income (GDP) causes a proportionately larger increase in capital investment.

How does the accelerator process work? (4 steps)

1. If a firm sees that GDP and AD are increasing, it needs to be certain that this will be sustained

2. Initially, the firm will use their existing capacity and work harder to meet growing demand

3. Once max capacity reached, firm will invest in capital if they believe growth will continue

4. This increase in investment will boost AD further assisting yet more growth

What does accelerator process show about investment?

It is more volatile than the rate of economic growth

This means that even if an economy is growing, investment may fall if this growth is slowing.

Multiplier effect - definition

Occurs when an initial injection into the economy or circular flow of income causes a larger final increase in the level of real national income/ output

What are the 3 injections (these start off the multiplier effect)

Government spending

Exports

Investment

How does the multiplier effect work?

Example:

1. Government invests £1bn in education to improve teacher’s pay and conditions

2. Teachers will spend some of that on goods and services - increasing consumption and AD

3. This will stimulate capital investment by firms, to meet this increased demand - AD increases more, another injection into circular flow

4. These firms may also hire new workers to meet demand, creating jobs and income - increasing consumption

5. Therefore, the initial $1bn injection into circular flow boosted AD and real GDP significantly more long term

What is the negative multiplier effect?

The inverse of it, occurs when an initial withdrawal leads to knock-on effects and a bigger final drop in real GDP

How does the negative multiplier effect work?

1. Initial withdrawal, like imports tax rises or spending cuts

2. Lead to a fall in GDP and negative multiplier

3. The size of the multiplier will be dependent on the Marginal Propensity to Consume (MPC)

4. If MPC = high, multiplier will be high, having a bigger negative effect, while if MP to save is high, multiplier will be lower, won’t be as detrimental.

Why does the MPC/MPS affect the size of the multiplier

Saving is a withdrawal from the circular flow, whereas consumption is part of it

If someone doesn’t save the money, will have little effect on economy, compared to someone who was going to spend it.

Why does the multiplier effect work like this?

Due to the idea of circular flow and that one agent’s spending is another agent’s income.

4 Factors affecting the size of the multiplier

1. Interest rates

2. Tax rates

3. Imports

4. Spare capacity

Interest rates: How does it affect the multiplier?

If high, consumption won’t rise significantly, as additional income may be saved rather than spent, which is a withdrawal from the circular flow

Tax rates: How does it affect the multiplier?

If high, consumers will be deterred from spending, or will simply have a lower disposable income with which to consume goods, so multiplier will be less.

Imports: How does it affect the multiplier?

In the UK, we have a high propensity to import goods

If disposable income increases due to an injection, but this money is spent on imports, multiplier will be lower as imports are a withdrawal, so AD and national income won’t rise

Spare capacity How does it affect the multiplier?

If a country’s economy has little spare capacity, any increase in consumption/AD may not be able to be met by firms, as they cannot increase supply quickly. This will reduce the multiplier size, and instead may cause inflation in the short term, as prices will rise due to increased demand, but stagnant supply.