The Multiplier Effect

What is the Keynesian concept of the multiplier?

• The multiplier effect describes how an injection into an economy such as an increase in government spending creates a ripple effect that increases employment and output of goods and services. It shows how much of a change to total income will come from the initial injection

• Larger multipliers suggest that injections have more of an impact

How does the multiplier effect work?

• An injection occurs in the economy such as an increase in government spending

• The injection increases AD in the economy for goods and services

• The increase in demand for goods and services causes firms to employ more workers and expand output

• As firms employ more workers, more people have disposable income, and subsequently the AD increases in the economy

What is the multiplier ratio

• It is the number of times a rise a national income exceeds the rise in injections that caused it

• Bigger the leakage the smaller the ratio

What happens if there is a higher leakage or withdrawal?

• The smaller multiplier will be

• If more money is leaking out of the circular flow, injections will have less of an impact on boosting income

• Leakages are saving, tax and imports

What is the marginal propensity to withdraw (MPW)

• This is a measure of how much extra money is saved, taxed, and spent on imports

• So if leakage is higher the MPW is higher

The calculation for MPW

Marginal propensity to tax (mpt) +Marginal propensity to save (mps) + Marginal propensity to import (mpm)

Calculation for Marginal propensity to tax

Increase in tax / Increase in income

Calculation for Marginal propensity to save

Increase in savings / Increase in income

Calculation for Marginal propensity to import

Increase in import / Increase in income

Calculation for Marginal propensity to consume

Increase in consumption / Increase in income

What are the formulas to calculate the multiplier

• 1 / MPW

• 1 / (MPT +MPS +MPM)

• 1 / (1-MPC)

What is the accelerator theory

• Is a theory of investment that relates the total level of investment to the rate of change in national income

• The level of investment depends upon the rate of change in national income or GDP

What is the accelerator effect

• Is when an increase in national income results in a proportionately larger rise in investment

Why is investment needed

• Needed to replace or purchase new capital stock

• when economic growth is positive and demand is rising, firms wish to increase their productive potential and supply capacityty to meet this rising demand

• Therefore level of investment rises

What happens to AD when there is an increase in injections

• AD shifts to the right

• Size of shift is determined by size of multiplier- grater multiplier larger the shift to the right of AD

What is the output gap

It measures the difference between the actual output of an economy and its potential output

Negative output gap

• Occurs when actual GDP is below potential GDP

• the economy is not producing to its productive potential or trend rate of economic growth because there are unemployed factors of production in the economy e.g. spare capacity

• Policymakers have the incentive to stimulate the economy through expansionary demand-side policy measure

Positive output gap

• Occurs when GDP is above potential GDP

• This will only happen in the short run

• economy producing above its productive potential and some resources are operating beyond their normal capacity e.g. labour working overtime

• Long run this will lead to the cost of production rising causing the short run of AS curve to shift to the left

• Will cause GDP to return to the trend rat

Cause of a negative output gap

• it is caused by actual GDP being below potential GDP when factors of production are under-utilised and some resources are unemployed

• Economic shocks such as demand-side shocks can cause negative output gaps e.g. COVID-19 led to a significant demand side-shock in the UK economy as consumers weren’t able to travel and purchase goods and services and household income fell due to a fall in demand leading to negative multiplier effect

Cause of positive output gap

Caused by actual GDP exceeding potential GDP as factors of production are employed above normal capacity (in the short run)

Consequences of a negative output gap

• They are more significant and are what is being referred to when economists talk about output gaps

• They can signal a lack of AD which can deter firms from investing and recruiting more staff affecting employment rate

Consequences of a positive output gap

• Results in inflationary pressure as AD outstrips AS

• however they are not long-term events and there will not be any long-term effects on GDP