The Multiplier Effect

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Introductory revision presentation on the multiplier effect

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The Multiplier Effect

  1. 1. The Multiplier Effect / Multiplier Process A change in one of the components of aggregate demand can lead to a multiplied final change in the level of GDP
  2. 2. The Multiplier Effect / Multiplier Process A change in one of the components of aggregate demand can lead to a multiplied final change in the level of GDP The multiplier effect comes about because injections of new demand for goods and services into the circular flow of income stimulate further rounds of spending – in other words “one person’s spending is another’s income” This can lead to a bigger eventual effect on output and employment
  3. 3. An Example of the Multiplier Effect The government injects £200m in a project to build thousands of new houses Why is the final increase in measured GDP likely to be more than £200m? If the final rise in GDP is £300m the value of the multiplier = 1.5 If the final rise in GDP is £250m the value of the multiplier = 1.25
  4. 4. An Example of the Multiplier Effect New build housing project injects £200m of new output into the economy Many businesses / sectors benefit directly – list four examples The government injects £200m in a project to build thousands of new houses Building new houses generates a new flow of factor incomes – including wages and profits Will the extra income stay inside the circular flow of income and spending? If so, the multiplier effect is likely to be strong
  5. 5. An Example of the Multiplier Effect New build housing project injects £200m of new output into the economy Many businesses / sectors benefit directly – list four examples The government injects £200m in a project to build thousands of new houses Building new houses generates a new flow of factor incomes – including wages and profits Will the extra income stay inside the circular flow of income and spending? If so, the multiplier effect is likely to be strong
  6. 6. An Example of the Multiplier Effect New build housing project injects £200m of new output into the economy Many businesses / sectors benefit directly – list four examples The government injects £200m in a project to build thousands of new houses Building new houses generates a new flow of factor incomes – including wages and profits Will the extra income stay inside the circular flow of income and spending? If so, the multiplier effect is likely to be strong
  7. 7. An Example of the Multiplier Effect New build housing project injects £200m of new output into the economy Many businesses / sectors benefit directly – list four examples The government injects £200m in a project to build thousands of new houses Building new houses generates a new flow of factor incomes – including wages and profits Will the extra income stay inside the circular flow of income and spending? If so, the multiplier effect is likely to be strong
  8. 8. An Example of the Multiplier Effect New build housing project injects £200m of new output into the economy Many businesses / sectors benefit directly – list four examples The government injects £200m in a project to build thousands of new houses Building new houses generates a new flow of factor incomes – including wages and profits Will the extra income stay inside the circular flow of income and spending? If so, the multiplier effect is likely to be strong
  9. 9. An Example of the Multiplier Effect The rate of leakage from the circular flow Assume that for each £100 pound of extra income generated • 10% is saved • 20% is taken in taxation • 20% leaks from the economy in imports The government injects £200m in a project to build thousands of new houses • The rate of leakage from the circular flow is vital to understanding the size of the multiplier effect
  10. 10. An Example of the Multiplier Effect • £20m saved • £40m taxed • £40m imports £200m Injection £100m extra GDP • £10m saved • £20m taxed • £20 imports • £Xm saved • £Xm taxed • £Xm imports £50m extra GDP At each stage the extra money flowing around the circular flow gets smaller
  11. 11. An Example of the Multiplier Effect The formal calculation for the value of the multiplier is Multiplier = 1 / (sum of the propensity to save + tax + import)
  12. 12. An Example of the Multiplier Effect Multiplier = 1 / (sum of the propensity to save + tax + import) If propensity to save = 0.1 Propensity to tax = 0.2 Propensity to import = 0.2 Then the multiplier = 1/0.5 = 2
  13. 13. An Example of the Multiplier Effect Multiplier = 1 / (sum of the propensity to save + tax + import) If propensity to save = 0.2 Propensity to tax = 0.3 Propensity to import = 0.3 Then the multiplier = 1/0.8 = 1.25
  14. 14. An Example of the Multiplier Effect When the rate of leakage from the circular flow is high ………. The value of the multiplier effect will be small Multiplier = 1 / (sum of the propensity to save + tax + import) If propensity to save = 0.2 Propensity to tax = 0.3 Propensity to import = 0.3 Then the multiplier = 1/0.8 = 1.25
  15. 15. Key Factors Affecting the Value of the Multiplier Propensity to import Avoiding crowding out effects Amount of spare capacity The value of the multiplier Propensity to save Propensity to tax
  16. 16. The IMF on the Fiscal Multiplier Government investment—things like infrastructure building—results in higher multipliers. Economists at the IMF have calculated the long-run multiplier at 1.5 for developed countries and 1.6 for developing countries. In other words, developing countries really benefit from government investment over government consumption. Investment can build the productive capacity of the economy, resulting in beneficial long-term effects. Many governments have been introducing fiscal austerity policies – cutting spending and lifting taxes in a bid to lower their budget deficits. The fiscal multiplier effect is important here too. If the multiplier is 0.5, then an initial government expenditure reduction of 1 per cent of GDP reduces real output by 0.5 per cent. If, however, the multiplier is 1.7, then the same initial public spending cut of 1 per cent of GDP would reduce real output by 1.7 per cent. The big danger of a high fiscal multiplier is that a period of deep cuts in state spending will cause an even larger drop in GDP which in turn will increase the size of the budget deficit. Fiscal austerity can turn out to be self-defeating. One problem is that the actual value of the multiplier effect is likely to change at different points of the economic cycle. (Source: Adapted from the Economist and other news reports, July 2013)
  17. 17. The Multiplier Effect in the News
  18. 18. What are the main objectives of macroeconomic policies? Price Stability – Low Positive Inflation Sustainable Growth of Real GDP Improved Competitiveness / Trade Falling Unemployment Sound Government Finances Higher Average Living Standards Equitable Distribution of Income and Wealth
  19. 19. AS Macro Course Support Get help from fellow students, teachers and tutor2u on Twitter: #econ2 @tutor2u @tutor2u-econ

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