Book 7 II C - Multiplier

Define multiplier effect

• (Def.): Refers to multiplied change in national income that results from an initial change in AD/injection/withdrawal in an economy

• AD shift along horizontal AS as prices are assumed to be unchanged

Describe CFOI + multiplier with numbers

• An initial increase in injections (of $100 million) will lead to an increase in households income (by $100 million)

• At this point, the economy is not at equilibrium as injections (J) are still greater than withdrawals (W) (J > W) 

• Shortage -> firms will face an unplanned decrease in inventories, signaling them to increase production -> hire more FOP -> with the households owning these FOP receiving higher income of $100 million

• The exact increase in each depends on the country's Marginal Propensity to Consume domestically produced goods and services (MPC) and MPS, MPT, MPM

• Assuming that the MPW of the economy is 0.6, the MPC will be 0.4 (MPC = 1 - 0.6) -> $100 million increase in income will cause the first group of households to spend an additional $40 million on domestically produced goods and services (this money go to firms which will go to next group of hh) 

• This will result in a second group of households enjoying a $40 million increase in income when firms pay them for use of their FOP, who would subsequently spend 0.4 of the $40 million - $16 million on domestically produced consumption goods and services with the other $24 million being withdrawn out of the economy as additional savings, taxes and imports

•  The increased induced consumption will now cause more firms to face an unplanned fall in inventories, inducing higher income generation for more households

• This cycle repeats itself until the total increase in withdrawals over time is equal to the initial increase in injections, with the total increase in income being $100 million + $40 million + $16 million + $6.4 million (40% of S16 million) + $2.56 million (40% of $6.4 million) and so forth

• At this point, since I = J, the economy is in equilibrium

• Total increase in national income would be greater than the initial increase in injections

Describe AD factor (CSQ version)

• Rise in AD will result in unplanned fall in inventories, causing firms to increase production and increase hiring of factors of production -> As households receive more factor income, they spend a portion of this additional income on domestic goods and services, while a part of it is withdrawn as savings, taxes and import expenditure. 

• The rise in induced consumption leads to AD rising again, which creates another round of unplanned fall in inventories and the process repeats itself until a new national income equilibrium is achieved. 

• Overall, there is a multiplied rise in real GDP from Y to Y’, as seen in Figure 1.

Describe multiplier effect (essay version)

1. Assuming there is spare capacity in the economy = horizontal ONLY not intermediate

2. An initial increase in AD (from AD0 to AD1) due to [factor Eg. Fall in investment] would lead to AD exceeding the current level of output causing a shortage 

3. As firms draw on their inventories to meet the extra demand, there would be an unplanned fall in inventories for firms

4. This signals firms to increase production -> Firms would then hire more factors of production, with the households owning these factors of production (labour) receiving higher income -> more willing and able to consume,

5. These households with higher income will be induced to consume more domestically produced goods and services and withdraw more in terms of savings, taxes and import expenditure

6. The greater induced consumption (NOT firms) would create another round of spending where there is an unplanned fall in inventories as total planned expenditure exceeds actual output of the economy again -> firms react again by increasing production and hiring more FOPs -> hh earn more factor income and GDP rises again from Y1 to Y2 

7. Hh will spend a portion on domestic G&S -> cause rise in induced Cd once more and another round of increase in withdrawals 

8. This will trigger multiple rounds of increases in income and the process continues until total W = total I again and a new equilibrium national income is achieved 

Describe link to real GDP for AD factor (essay version)

1. Real GDP: Overall, the rise in real GDP is to a larger extent than the initial rise in AD due to multiplier effect leading to actual economic growths

Extent in shift in AD depends on: 

Extent in shift in AD depends on: 

1. Size of k 

2. Extent in cut of interest rate (If it only falls by 1% -> C won't increase much) 

3. Spare capacity (If already near Yf, k will not take full effect) 

• Singapore’s unemployment rate is relatively low at around 3% = economy is likely operating near full employment level. 

• Further increases in AD without an accompanying rise in productive capacity would only lead to increases in GPL and a minimal rise in real GDP

1. Time lag 

2. Structural rigidities (not enough infrastructure, hard to hire people)

Define multiplier

• Multiplier k (Def.): number of times by which a rise in equilibrium national income exceeds the rise in autonomous expenditure

• Marginal propensity = For every $1 of additional income earned, how many cents goes to ____

• k x initial change in AD = final change in GDP

Stste MP formulas, what is MPT/S/W/M/C

MPT	MP to tax (direct tax - income and corporate tax) NOT GST
MPS	MP to save
MPM	MP to import
MPW	MP to withdraw
MPC	MP to consume domestically produces G&S

MPW = MPM + MPT + MPS 

MPW + MPC = 1

k = 1/MPW = 1/1 - MPC

Describe SG MPW + this effect

For SG: K small, MPW large = MPT low (to attract foreign talent and investment) + MPS high (Asian thrift + (main reason) compulsory CPF - increase MPS by 0.2%) + MPW high (poor resource endowment) -> low MPC → A large portion of the G will be withdrawn out of the economy and less money flows back to the firms -> smaller multiplier size and a less significant increase in national income

Describe link to unemployment rate for AD factor (essay version)

1. Unemployment rate: higher AD -> firms increase production -> increase use of FOP -> increase derived demand for labour -> increase demand-deficient labour, assuming labour force unchanged -> unemployment rate decrease 

Describe link to GPL for AD factor (essay version)

1. GPL: Since the economy is operating near the level of full employment, the increased derived demand for FOP will cause a greater competition for limited factors of production and increase the unit cost of production -> Firms will pass on this increased cost of production to the economy to maintain profitability, causing the GPL to rise from P1 to P2