A-Level Economics Notes on The Multiplier

Definitions

1. Multiplier Effect: The proportional amount of increase, or decrease, in final income that results from an injection, or withdrawal, of spending.
2. Marginal Propensity to Consume (MPC): The fraction of additional income that a household consumes rather than saves. It’s calculated as the change in consumption divided by the change in income.
3. Marginal Propensity to Save (MPS): The fraction of additional income that a household saves rather than spends on consumption. It’s calculated as the change in saving divided by the change in income.
4. Marginal Propensity to Tax (MPT): The fraction of additional income that is taxed away. It reflects the increase in tax payments that results from an increase in income.
5. Marginal Propensity to Import (MPM): The fraction of additional income that is spent on imports. It indicates the increase in import spending that results from an increase in income.
6. Injection: Money added to the economy’s circular flow; this can include investments, government spending, and exports, which stimulate economic activity.
7. Withdrawal (or Leakage): Money taken out of the economy’s circular flow; this includes savings, taxes, and imports, which can dampen economic activity.
8. Aggregate Demand: The total demand for goods and services within the economy at a given overall price level and in a given time period.
9. Fiscal Policy: Government policy that attempts to influence the direction of the economy through changes in government spending or taxes.
10. Autonomous Spending: Spending that does not depend on the level of GDP. This can include investment, government spending, and net exports.
11. Induced Spending: Spending that is influenced by the state of the economy, such as consumer spending that increases with GDP.
12. Equilibrium National Income: The level of national income where aggregate demand equals aggregate supply (or, in Keynesian terms, where planned expenditure equals actual expenditure).
13. Excess Capacity: When a business or economy can produce more goods than are being produced, often due to a lack of demand.
14. Full Employment: The level of employment at which virtually all individuals willing and able to work at prevailing wage rates are employed.
15. Crowding Out Effect: A situation where increased public sector spending replaces, or drives down, private sector spending.
16. Simple Multiplier: A basic multiplier used in fiscal policy analysis, which assumes no taxes, no imports, and no price changes.
17. Complex Multiplier: A more realistic multiplier that takes into account taxes, imports, and price level changes.
18. Time Lags: The delays that occur in the economy as a result of time taken for decisions to affect economic variables.
19. Rational Expectations: The theory that people learn from past experiences and make decisions based on their predictions of future consequences of present actions.
20. Keynesian Economics: An economic theory stating that active government intervention in the marketplace and monetary policy is the best method of ensuring economic growth and stability.

The Multiplier Effect

Definition

The multiplier effect refers to the process by which an initial increase in spending leads to an even greater increase in national income.

Origin

• The concept originates from Keynesian economics, developed by John Maynard Keynes, who suggested that spending stimulates production and income, leading to more spending and a virtuous cycle of economic activity.

Formula

• The simple multiplier formula is: Multiplier (k) = 1 / (1 – MPC) or Multiplier (k) = 1 / MPS + MPT + MPM
  • Where MPC is the marginal propensity to consume, MPS is the marginal propensity to save, MPT is the marginal propensity to tax, and MPM is the marginal propensity to import.

Types of Multipliers

1. Fiscal Multiplier: Change in national income arising from a change in government spending.
2. Tax Multiplier: Change in national income initiated by a change in taxes.
3. Money Multiplier: The ratio of the change in the money supply to the change in reserves.
4. Employment Multiplier: The number of jobs created for every unit of currency spent.

Working of the Multiplier

• Initial Injection: An initial increase in spending (investment, government spending, exports) serves as an injection into the economy.
• Consumption Cycle: The initial spending creates income for those who receive it, who then spend a portion of this income, creating further income for others.
• Diminishing Increments: With each round, the additional spending and income generation are less than in the previous round because some income is lost to savings, taxes, and imports.
• Equilibrium: The process continues until the additional spending is so small that it approaches zero, and a new equilibrium level of national income is reached.

Factors Affecting the Size of the Multiplier

• Marginal Propensities: The higher the marginal propensity to consume, the larger the multiplier effect.
• Leakages: Savings, taxes, and imports are considered leakages from the income stream and reduce the size of the multiplier.
• Time Lags: Delays in consumption or investment can dampen the multiplier effect.
• Excess Capacity: The multiplier is larger when there is excess capacity in the economy. If the economy is at full capacity, the multiplier effect is reduced.
• Confidence: Economic or political stability can affect the confidence of consumers and investors, thereby influencing the multiplier.

Importance of the Multiplier

• Policy Implications: Understanding the multiplier effect is crucial for fiscal policy. It helps policymakers predict the impact of their fiscal decisions on aggregate demand and income.
• Economic Recovery: In times of recession, the multiplier can be used to justify increased government spending to boost economic activity.
• Inflation Control: In an overheated economy, recognizing the multiplier effect can lead to restrained fiscal policy to prevent inflation.

Criticisms

• Assumption of Unchanged Prices: The multiplier theory assumes that prices remain constant, which may not hold in the real world.
• Crowding Out: Increased government spending may lead to a ‘crowding out’ of private investment, potentially reducing the multiplier effect.
• Rational Expectations: Some economists argue that people may anticipate the inflationary effects of increased spending and adjust their behavior, reducing the multiplier’s effectiveness.

Real-World Application

• Great Depression: The New Deal programs in the United States during the 1930s were based on the multiplier concept to revive the American economy.
• 2008 Financial Crisis: Stimulus packages introduced by governments worldwide post-2008 crisis were designed considering the multiplier effect to restore economic growth.