The concept of the multiplier

What is the multiplier effect?

Describes how a change in autonomous spending will cause a larger change in income.

Important saying

One person’s spending is another person’s income

What is the multiplier?

The amount by which income changes after an initial change in autonomous expenditure.

What are the different equations to calculate the multiplier?

k = ΔΥ / ΔΙ

k = 1 / (1- MPC)

k = 1/MPS

What would happen if the mpc increased?

This would increase the ‘re-spending’ effect from a given change in investment, so the size of the multiplier would rise.

How does the mpc effect the multiplier?

Small changes in the mpc can have a dramatic effect on the size of the multiplier.

As mpc increases, the multiplier increases.

What determines the value of the marginal propensity to consume?

It depends on attitudes to spending and saving and may change over time. The mpc is an average across all households in the economy.

When can the multiplier principle impact the Australian economy?

The multiplier process applies to any autonomous change in expenditure such as consumption, investment, government spending or net exports.

What are some examples of when the multiplier principle impacts the Australian economy?

• investment projects in the mining region of WA

• government spending on defence

• increased exports due to higher commodity prices

How can the multiplier process work in reverse?

• A decline in business confidence would decrease planned investment

• A contraction in the Chinese economy would decrease the volume of Australia’s exports.

  Each of these changes in autonomous spending would result in a larger decrease in real GDP due to the multiplier effect.

Fill in the blanks in the blue table

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Why is the change in consumption decreasing and when will this change stop?

Because the mpc is less than 1 and will stop when the incremental change is zero

If the process was complete what will be the total change in income?

The initial investment multiplied by the multiplier

What determines the size of the multiplier?

Determined by factors affecting the marginal propensity to consume.

What are the limits to the multiplier?

If the mpc was equal to one, than the multiplier would equal infinity. In reality, there are a number of factors which restrict the value of the mpc and therefore reduce the size of the multiplier.

What are the factors that restrict the multiplier known as?

These factors are the leakages associated with savings, taxation and imports. Each of these leakages reduces the size of the multiplier.

When leakages are taken into account what is the formula for the multiplier?

k = 1 / (MPS + MPT + MPM)

where:

• MPS = marginal propensity to save

• MPT = marginal propensity to tax

• MPM = marginal propensity to import

What is the value of the multiplier in the Australian economy?

Estimates indicate that the multiplier varies over the course of the business cycle but averages between 2.0 and 2.5.

What is the benefit of knowing an average estimate value of the multiplier?

This is useful information for the governments when formulating policy tools for different phases of the business cycle.

What would the multiplier be if the mpc was 0?

1

What would the multiplier be if the mpc was 1?

Infinity

What does the aggregate expenditure model demonstrate in relation to the aspects of the multiplier?

Demonstrates how an increase in investment causes the equilibrium level of income to increase by a much larger amount.

Draw the multiplier effect diagram

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With each round of spending how does the level of income in the economy change?

The level of income in the economy will expand in successive rounds of new spending which generates new income. Each change in income will induce new consumption spending via the marginal propensity to consume.

What events would cause an increase in aggregate expenditure?

• a rise in consumer spending due to an increase in household wealth

• an increase in business investment associated with increased profitability

• the Government increases spending on healthcare

• an increase in net exports due to higher commodity prices

How does an increase in the level of aggregate expenditure affect the AE function?

Will shift the model upwards at all levels of spending.

What is an example of the circular flow of income?

For example a mining company decides to spend $100 million to develop a mine site in WA. The new investment creates income for contractor firms and their employees. These households then spend part of that income on g/s. This spending will flow on to other people through the circular flow of income. The final impact of the new spending is thus likely to be much greater than the initial investment spending.