Multiplier

The Multiplier Effect

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. 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. 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
 .

Only when taxes change with

. national income
Multiplier =
1/1-mpc+mpm+mpt

1 -0.1 - 0.2- 0.2

• 5m saved
• 10m taxed
200 *.1 • 10m imports
200 * .2
200 * .2

1- 0.9 +0.2+0.2
= 0.5
s.
● What determines the value of the multiplier?

● The value of the multiplier depends on:

● Propensity to import

● Propensity to save

● Propensity to tax

● Amount of spare capacity

● Avoiding crowding out

● Key points

● 1.The higher is the propensity to consume domestically produced goods and services, the greater is the multiplier
effect. The government can influence the size of the multiplier through changes in direct taxes. For example, a cut in
the rate of income tax will increase the amount of extra income that can be spent on further goods and services

● 2.Another factor affecting the size of the multiplier effect is the propensity to purchase imports. If, out of extra
income, people spend their money on imports, this demand is not passed on in the form of fresh spending on
domestically produced output. It leaks away from the circular flow of income and spending, reducing the size of the
multiplier.

● 3.The multiplier process also requires that there is sufficient spare capacity for extra output to be produced. If
short-run aggregate supply is inelastic, the full multiplier effect is unlikely to occur, because increases in AD will
lead to higher prices rather than a full increase in real national output. In contrast, when SRAS is perfectly elastic a
rise in aggregate demand causes a large increase in national output.

● 4.Crowding out – this is where (for example) increased government spending or lower taxes can lead to a rise in
government borrowing and/or inflation which causes interest rates to rise and has the effect of slowing down
economic activity.
When will the multiplier effect be large?

In short – the multiplier effect will be larger when

● The propensity to spend extra income on domestic goods and services is high

● The marginal rate of tax on extra income is low

● The propensity to spend extra income rather than save is high

● Consumer confidence is high (this affects willingness to spend gains in income)

● Businesses in the economy have the capacity to expand production to meet increases in demand
Elasticity of aggregate supply and the multiplier effect Key point summary on
Show the impact of increase in Investment Expenditure by Rs 1000 if the value of Mpc is 0.8 on National
Income

Round 1 – Initial increase in Investment expenditure by 1000

Round 2

Round 3

Round 4

Round 5

Sum of all 5 rounds

Sum of all subsequent Rounds

Total
The total height of each bar shows the
full increase in national income as a
result of an increase in investment
expenditure of $1000

The shaded part shows the increase

over the previous round of
expenditure .Each increase is a 80% of
the previous increase because MPC is
0.8-

1000 800 640 512 410 328 262 210 168 134
● 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. The reason for this is that developing countries have lower income and consume a
high part of their income .Hence the value of the multiplier is stronger.
● IF MPC is high , value of multiplier will be high.
● If MPC is low value of Multiplier wll be low .
● 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.
K= 1/mps or 1/1-mpc if K = 0.5 , change in NI = multiplier * Government spending, 0.5*1% = 0.5%
● 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 p%

Change in National Income = 1.7 * 1%= 1.7%

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 as government revneue
will delcine due tax collection etc.

■ Budget Deficit = GE > GR (Taxes etc)

■ Government Reduces expenditure
■ GDP will decrease by a multiple amount
■ As a result tax revenue will decrease –
■ Budget deficit will worsen.
New investment of Rs. 1000 crores

Let us suppose that a hypothetical economy behaved in the following sim­ple way: every time any
household receives some ex­tra income it immediately spends 4/5 of it on consump­tion goods (MPC =
4/5) and saves the remaining portion of it.

What will the net increase in income? (Numerical and Graph)

GDP = Multiplier * AE
New investment of Rs. 1000 crores
Let us suppose that a hypothetical economy behaved in the following sim­ple way: every time any
household receives some ex­tra income it immediately spends 4/5 of it on consump­tion goods (MPC =
4/5) and saves the remaining portion of it.

What will the net increase in income?

MPS1 = ⅕= 0.2

Multiplier = 1/MPS 1/0.2 = 5

= 1000 * 5 =5000 crores

AE 200

GDP
400
(a) Derive the multiplier when the MPC is 0.90, 0.80, 0.75 and 0.50.

(b) What is the relationship between the marginal propensity to con­sume and the value of the multiplier?

(c) Use the multiplier values found in (a) to establish what effect a Rs. 20 decrease in autonomous spending
has upon equilibrium income.

Sol:

(a) The multiplier m equals 1/(1-b), thus,

m is 10 when the MPC is 0.90;

5 when MPC is 0.80;

4 when MPC is 0.75; and

2 when MPC is 0.50.

(b)What is the relationship between the marginal propensity to con­sume and the value of the multiplier?

(b) The he value of the mul­tiplier is directly related to the value of the marginal propensity to consume.
here is a multiplier effect because consump­tion spending is related to the level of disposable in­come. Any
change in income induces a change in aggregate consumption, with the magnitude of the change
dependent on the value of the marginal propensity to consume. Y= c+s ., when Y increases, C also
inceases.

(c) Use the multiplier values found in (a) to establish what effect a Rs. 20 decrease in autonomous
spending has upon equilibrium income.

(c) The decline in income equals ∆Ī(m). Rs. 20

The de­crease in equilibrium income is

Mpc =0.9 ,M= 10 ,Rs 20*10 = 200 ---Rs. 100, Rs. 80 and Rs. 40 for the four values of MPC. respec­
tively.
Q. If investment falls Rs. 20 and the marginal propensity to consume is 0.60, what are (a) the change in the
equilibrium level of income, (b) the change in autonomous spending and (c) the induced Change in consumption
spending?

Gdp = Multiplier* AE
Q. If investment falls Rs. 20 and the marginal propensity to consume is 0.60, what are (a) the change in the
equilibrium level of income, (b) the change in autonomous spending and (c) the induced Change in consumption
spending?

Sol:

(a) The change in the equilibrium level of income equals k∆Ī. Since k = 2.5, ∆Y = – Rs. 50.

mps=0.4, 1/0.4 =2.5 , 20*2.5=50

(b) The Rs. 20 decline in investment is the change in autonomous spending.

(c) Iduced spending falls by Rs. 30.

C= .6 (50) =30
Q.Suppose I = Rs. 70; C = Rs. 60 + 0.80 Y.

(a) Find the equilibrium level of income,

(b) Find the equilibrium level of income when there is a Rs. 10 increase in autonomous planned
investment (planned investment increases from Rs. 70 to Rs. 80).

(c) Establish the multiplier effect of the Rs. 10 increase in autonomous spending.]
Q.Suppose I = Rs. 70; C = Rs. 60 + 0.80 Y. (a) Find the equilibrium level of income, (b) Find the
equilibrium level of income when there is a Rs. 10 increase in autonomous planned investment
(planned investment increases from Rs. 70 to Rs. 80). (c) Establish the multiplier effect of the Rs.
10 increase in autonomous spending.

(c) The equilibrium level of income increases by Rs. 50 (from Rs. 650 to Rs. 700) as a result of a
Rs. 10 increase in investment. There is a multiplier effect of 5 (that is, ∆Y/∆I = Rs. 50/ Rs. 10 = 5 or
1/mps =1/0.2) as a result of the increase in autonomous investment,
 ● Draw an Investment and Saving Graph using the following values .

● Increase in investment by 200

● Mps 0.2

Mps 0.4

Mps 0.6

Graphically show the impact on National Income

An increase in Investment
will increase GDP by a
higher amount if the MPS
Value is lower .

S1= 0.6 k=?

S2=0.4k=?
S3 =0.2 k=?

The steeper the line higher is

the value of mps.
Calcute multiplier values
The formal calculation for the value of the multiplier is Multiplier = 1 / (sum of the propensity to save +
propensity to tax + propensity to import)

If propensity to save = 0.1 Propensity to tax = 0.2 Propensity to import = 0.2 Then the multiplier = 1/0.5 =
2
If propensity to save = 0.2 Propensity to tax = 0.3 Propensity to import = 0.3 Then the multiplier = 1/0.8 =
1.25
Tax Multiplier
● Tax multiplier represents the multiple by which GDP increases (decreases) in response to a decrease
(increase) in taxes charged by governments.

● Assume the government decreases tax rates by 5% which is expected to reduce total tax volume by
$300 billion.

● This increases disposable income by $300 billion.( This entire amount of 300 will not be injected in the
economy as households save part of their income)

● Assume further than the marginal propensity to consume is 0.8.

● Households will spend $240 billion of the increase in disposal income (= 0.8 × $300 billion). The first-
round of increase in consumption of $240 billion will trigger second round of increase in disposable
income of the same amount, which in turn will trigger second-round of consumption increase of $192
billion (= 0.8 × 0.8 × $300 billion), and so on.

● The final outcome is that the GDP increases by a multiple of initial decrease in taxes. This multiple is the
tax multiplier. On the other hand, an increase in taxes decreases GDP by a multiple in the same fashion.
The simple version of tax multiplier, it is assumed that any increase or decrease in tax affects
consumption only (and has no effect on investment, government expenditures etc.)

Tax Multiplier = or mpc/1-mpc

● Given the same value of marginal propensity to consume, simple tax multiplier will be lower than the
spending multiplier.

● This is because in the first round of increase in government expenditures, consumption increases
by 100%, while in case of a decrease in taxes of the same amount, consumption increase by a
factor of MPC.
● Increasing government expenditures and investment is more effective than decreasing taxes in
increasing the GDP because it requires lower increase in budget deficit.

● The target increase in GDP of $40 billion can be achieved by increasing government expenditures
and investment by $10 billion. $13.3B of tax reduction would be needed if the country decides to
achieve the target growth in GDP by decreasing taxes. This is because spending multiplier is higher
than the tax multiplier. Relevant calculations are shown below.

● Spending multiplier = 1/MPS = 1/0.25 = 4

● Tax multiplier = MPC/(1 − MPC) = 0.75/0.25 = 3

● Increase in government expenditures needed = target change in GDP/spending multiplier = $40B/4

= $10B y= K*G 40 = 4*G - 40/4= 10b

● Decrease in taxes needed = target change in GDP/tax multiplier = $40B/3 = $13.3B

y=K*T - 40=3 *T , 40/3 =T 13.3B

 ● What determines the size of Multiplier?

● The size of the multiplier depends on withdrawals and the marginal propensity to consume

● If consumer spend 90% of their extra income, the multiplier effect will be high. If they spend only 10%
of extra income the multiplier effect will be low.

● A cut in income tax means that people keep a high % of their gross income.

● Multiplier Formula = 1 / 1-mpc

 It depends on which rate of income tax is cut. For example, high-income earners have a lower marginal propensity to
consume – they find it harder to find things they need to buy. If you cut the top rate of income tax, a higher % of the tax cut
will be saved. Therefore, the multiplier effect will be lower.

 If the income tax rate for low-income earners is cut (e.g. raising income tax threshold). This will have a  bigger impact on
increasing spending because low-income earners have a higher marginal propensity to spend.

 It may also depend on whether households expect the tax cut to be temporary or permanent . For example, if the
government cut taxes by increasing borrowing, then householders may feel in the future tax rates will have to rise to reduce
the deficit. In this case, more of the tax cut will be saved rather than spent.
● Marginal propensity to import (MPM). If the economy has a high propensity to spend extra income
on imports, then the multiplier effect will be lower.

● State of the economy. If the economy is close to full capacity, a cut in income tax may cause only a
minor increase in real output. – the tax cut will be inflationary. However, if there is spare capacity
(the economy is in recession) then the multiplier effect will be bigger as the tax cut may encourage
unused resources to become used.
 Multiplier-What is a simple definition of the multiplier?

Consider a £300 million increase in capital investment– for example created when an overseas company
decides to build a new production plant in the UK
● This may set off a chain reaction of increases in expenditures. Firms who produce the capital goods
and construction businesses who win contracts to build the new factory will see an increase in their
incomes and profits
● If they and their employees in turn, collectively spend about 3/5 of that additional income, then £180m
will be added to the incomes of others

At this point, total income has grown by (£300m + (0.6 x £300m).

The sum will continue to increase as the producers of the additional goods and services realize an increase
in their incomes, of which they in turn spend 60% on even more goods and services.
The increase in total income will then be (£300m + (0.6 x £300m) + (0.6 x £180m).
Each time, the extra spending and income is a fraction of the previous addition to the circular flow.