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Multiplier Effect

The Multiplier Effect is an economic term referring to how an increase in one economic activity
can cause an increase throughout many other related economic activities. There are several ways
to envision this in the economy. For example, lets say SuperTech Company introduces a new
product with high sales. SuperTechs success leads to growth for its raw materials suppliers that
in turn causes growth in machine rate to extract more raw materials and that causes growth in the
other industries. This growth upon growth is the Multiplier Effect. Similarly, SuperTechs new
growth creates greater income for its employees. These employees spend a portion of their higher
income on new things such as restaurants, clothing, and cars. This generates new income for all
the suppliers and employees in the supporting industries. The accumulated new income is much
greater than the initial new income.
The Multiplier Effect is also at work when the banking industry lends money to customers. For
example if Mr. Myungsoo deposits P1000 in the bank, the bank must by law hold a part of that in
reserve but can lend the rest of it back out. If it must hold 20% in reserve, it can lend out 80%, or
P800. That P800 may be spent several times, but eventually, someone puts it in another bank.
This bank keeps 20%, or P160, and lends out P640. This cycle repeats several times. After all the
depositing and lending, Mr. Myungsoos P1000 could become several thousand pesos in
deposits.

Further explanation of Multiplier Effect:


The fiscal multiplier effect occurs when an initial injection into the economy causes a bigger
final increase in national income.
For example, if the government increased spending by 1 billion, there would be an initial
increase in Aggregate Demand of 1bn. However, if this injection eventually caused real GDP to
increase by 2 billion, then the multiplier would have a value of 2.0
Multiplier (k)

Change in Real GDP (Y)


Change in Injections (J)
Example of How the Multiplier Effect Works

If the government spent an extra 2 billion on the NHS this would cause salaries / wage
to increase by 2 billion, therefore National Income will increase by 2 billion.

However with this extra income, workers will spend, at least part of it, in other areas of
the economy.

For example, if they spent 50% of the extra income there would be another 1 billion
injected into the economy. e.g. shopkeepers would earn money from increased sales.

This extra spending would cause an increase in output, therefore firms would employ
more workers and pay higher salaries.

Therefore these workers will also increase their spending. This will lead to another
injection into the economy, causing higher Real GDP

In other words, if you increase salaries in the NHS, it isnt just NHS workers who benefit
from higher incomes. It is also related industries and service industries who see some
benefits.

AD = C + I + G + X M
Injections can include:

Investment (I)

Government Spending (G)

Exports (X)

Negative Multiplier Effect


The multiplier effect can also work in reverse. If the government cut spending, some public
sector workers may lose their jobs. This will cause an initial fall in national income. However,
with higher unemployment, the unemployed workers will also spend less leading to lower
demand elsewhere in the economy.
The value of the Multiplier depends upon:

If people spend a high % of any extra income, then there will be a big multiplier effect.

However if any extra money is withdrawn from the circular flow the multiplier effect will
be very small.

k=
1
1-mpc

1
mpw

1. Marginal Propensity to Consume (mpc). This is a persons willingness to spend money, if


a worker saved all his money there wouldnt be an increase in GDP

2. Marginal Propensity to Withdraw (mpw). This is when money is withdrawn from the
circular flow it includes mpt + mpm + mps
3. The Marginal Propensity to Tax
4. The Marginal propensity to Import
5. The Marginal Propensity to Save

(mpt)
(mpm)
(mps)

The multiplier will also be effected by the amount of spare capacity if the economy is close to
full capacity an increase in injections will only cause inflation.
Multiplier Effect of a Tax Cut

A tax cut has no effect on government spending, but, it should effect Consumer spending
(C) and I (investment)

For example, imagine the government cut VAT from 17.5% to 15%. This has two effects:

1. Firstly, if consumers maintain the same spending habits, they will have more disposable
income left over to buy more goods.
2. Secondly, they may be encouraged to buy goods (especially expensive electrical goods)
e.t.c because they are cheaper.

Therefore, in theory, a tax cut should boost consumer spending and this leads to an
overall rise in AD.

This means firms will get an increase in orders and sell more goods. This increase in
output, will encourage some firms to hire more workers to meet higher demand.
Therefore, these workers will now have higher incomes and they will spend more. This is
why there is a multiplier effect. Extra spending benefits others in the economy.

Crowding Out
Monetarists argue the fiscal multiplier will be limited by the crowding out effect. E.g. if the
government increase Aggregate Demand through higher spending or tax cuts then this increases
consumer spending. However, the rise in borrowing (and higher bond yields) leads to a decline in
private sector investment. Therefore, there is no overall increase in AD.

Equilibrium level of national income and government expenditure


In an open economy, the circular flow model of national income consists of five sectors as shown
in figure 1 below.
Figure 1: Circular Flow of National Income in a Five Sector Model
The figure above illustrates the five sector circular flow model, which can be described as a
model based on income flows from one sector of the economy to another in a circular flow
motion, which explains the level of national income.
The main sectors of the economy include households and firms. In the two sector model
consisting only of households and firms, the economy is always at equilibrium. That is Income
(Y) is always equal to consumption (C). However, the economy cannot be limited only to these
two sectors. The effects of banks, government and international trade must be taken into
consideration. These three sectors bring about withdrawals and injections. The financial sector
mobilises savings (S) from households and makes investments (I) to firms. The government
sector collects taxes (T) from households and makes expenditure (G) on firms. Finally, in the
balance of payments sector, part of household income is spent on imports (M) while some
revenue is received as exports (X).
Since the two sector model always results to equilibrium, any distortion in
equilibrium will result from the impact of the other three sectors. From the figure
above, the national income is given by:

Y = C +S+T+M (I+G+X)
For equilibrium to be achieved, total leakages must be equal to total injections. That is, S+T+M
= I+G+X. Therefore, the equilibrium level of national income is simply given by:
Y=C.
The Keynesian cross model shows how consumption is determined. Under normal conditions,
households will consume all goods and services produced. In this case, consumption will be
exactly equal to income. This is represented by the 45 degree line in figure 2 below. Keynes
noted that the relationship between consumption and income could not be perfect as the one
depicted by the 45 degree line. He noted that not everybody in the economy earns income but
everybody consumes. Therefore, there is a certain amount of consumption that does not depend

on income and a certain amount that depends on income. From the foregoing, Keynes suggested
the following consumption function (Mankiw, 2009: 497):
Where = constant is defined as the consumption that does not depend on income; c is the slope of
the consumption function referred to as the marginal propensity to consume. The marginal
propensity to consume lies between 0 and 1. This indicates that consumption increases as income
increases but the rate of increase in consumption is not as much as the rate of increase in income
(Mankiw, 2009: 496).
Figure 2: The Keynesian Cross
450
Consumption (C)
National income (Y)
Y*
According to the Keynesian cross model, the equilibrium level of national income Y* is achieved
at the point where the consumption function intersects the 45-degree line. At this point, all
income that is earned is consumed. This is also the point where the desired level of spending is
equal to the national income (Suranovic, 2005).
Aggregate demand (AD) is the total or aggregate expenditure of final goods and services in an
economy over a given period of time say one fiscal year. The aggregate demand is represented
depending on whether it is a closed or open economy. For an open economy, the aggregate
demand is given by:
Y = AD = C+I+G+X-M
For a closed economy, the aggregate demand is given by:
Y = AD = C+I+G
In the closed economy case, X-M is considered to be zero since there are neither imports nor
exports.
The aggregate demand curve is downward sloping. It shows the relationship between the
quantity of real GDP demanded and the price level (Parkin, 2009: 324). The AD curve is as
shown in the figure below.
Figure 3: Aggregate Demand (AD) Curve
AD

Price Level (P)


National income (Y)
Aggregate supply (AS) refers to the aggregate or total supply of final goods and services or real
GDP in an economy over a given period of time. The national income or real GDP is given by:
Y = GDP = C+I+G+X-M. Unlike the AD curve, the AS curve is upward sloping. It shows the
relationship between aggregate supply of final goods and services and price levels. This is
represented in figure 4 below.
AS
Price Level (P)
National income (Y)Figure 4: Aggregate Supply (AS) Curve
Figure 5: Aggregate Demand-Aggregate Supply Framework (Macroeconomic Equilibrium)
AS
Price Level (P)
National income (Y)
Y*
P*
AD
Macroeconomic equilibrium is defined as a situation where aggregate demand and aggregate
supply are equal without any tendency for change (Chiang and Wainwright, 2005: 30). At this
point a given price level ensures that the final goods and services demand is exactly equal to the
final goods and services supplied. As shown in figure 5 above, this price level is referred to as
the equilibrium price level (P*) and the real GDP or national income at this price level is the
equilibrium level of national income (Y*). At this level of national income, the aggregate supply
curve intersects the aggregate demand curve.
Multiplier effect caused by an Increase in Government Expenditure
From the circular flow model above, a multiplier effect from government expenditure will lead to
an increase in government expenditure. Firms will increase investment in capital goods,
employment will increase, and wages will increase. The increase in wages will lead to an
increase in consumption, savings and taxes. Both imports and exports will also increase.

In the long-run, the total amount of leakages will exactly equal the total amount of injections.
There will be an overall increase in national income and the equilibrium level of national income
will be higher than before.
Using the Keynesian Cross, an increase in government expenditure will result to an increase in
national income through increases in wages, consumption, savings, investment, imports and
exports.
450
Consumption (C)
National income (Y)
Y*
Y1*
As income rises, the average propensity to consume (APC) which measures slope of the line
from the origin to the consumption function will decrease (Mankiw, 2007: 497). This will lead to
an increase in the equilibrium level of national income from Y1*.
AS
Price Level (P)
National income (Y)
Y*
P*
AD
AD1
AS2
In the AD/AS model, an increase in government expenditure will result to an increase in
aggregate demand. An increase in aggregate demand will motivate firms to increase investment.
Employment will increase leading to an increase in wages. Savings will increase as well as taxes.
In addition imports and exports will rise. The overall effect will be an increase in aggregate
supply and aggregate demand. This will result to a rightward shift in the aggregate demand and
supply curves as shown in figure 6 below.
Consumer Confidence

If consumer confidence is high, people tend to consume more of current income. In the circular
flow model, the multiplier effect will be higher if consumer confidence is high. That is the
respond to an increase in government spending will be higher than the case would be if consumer
confidence is low. Households will consume more of their current levels of income as they
anticipate an increase in future income. In like manner, firms will increase investment,
employment will increase, and savings will reduce. Moreover, taxes will increase as well as
imports and exports.
In the Keynesian cross model, consumer confidence will lead to an increase in the marginal
propensity to consume. People will be willing to consume more of their current incomes as they
anticipate increases in future incomes.
In terms of the AS/AD framework, a higher consumer confidence will lead to a significant
increase in aggregate demand. This will in turn result to higher rates of investment spending,
taxes, imports and exports. The overall impact will be a rightward shift in the AS and AD curves
to establish a new equilibrium level of national income.

Sources:
http://www.economicshelp.org/blog/1948/economics/the-multiplier-effect/
http://www.ukessays.com/essays/economics/equilibrium-level-of-national-income-andgovernment-expenditure-economics-essay.php