2.3. THE MULTIPLIER EFFECT
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The multiplier effect refers to the increase in final income arising from any new injection of spending. When an injection of new demand occurs in an economy, it will travel round the circular flow of income many times. For example, an increase in government spending will mean the firms increase their sales, resulting in more factors of production being demanded. As more factors of production are demanded, more individuals are receiving a wage/ receive a higher wage which means that workers have higher incomes that they can spend in the economy which results in more consumption. This increase in consumption requires more factors of production and this scenario occurs time and time again. The size of the multiplier is dependent on households’ marginal propensity to consume (MPC) and marginal propensity to save (MPS). The marginal propensity to consume works out how much more additional income you would consume. Suppose my income increased by £1000. With this increase in income, I can either choose to spend it or choose to save. If I spend £700 of it, my marginal propensity to consume works out to be 0.7, because 700/1000. By spending £700 I have £300 left and I choose to save this. Therefore, my marginal propensity to save works out to be 0.3 (300/1000).
The multiplier is calculated using the following formula
1/1-MPC
The multiplier is calculated using the following formula
1/1-MPC
An Example
Suppose that households in the economy spend 0.75 and save 0.25 of every £1 of additional income, then what would the multiplier be?
The Marginal propensity to consume is 0.75 and the marginal propensity to save is 0.25. This results in the multiplier becoming:
Suppose that households in the economy spend 0.75 and save 0.25 of every £1 of additional income, then what would the multiplier be?
The Marginal propensity to consume is 0.75 and the marginal propensity to save is 0.25. This results in the multiplier becoming:
=1/(1-0.75)
= 1/0.25
= 4
= 1/0.25
= 4
The multiplier is 4. For every £1 new income generates £4 of extra income. Governments need to be aware of the value of the multiplier when deciding on their economic policy. Suppose that the economy had an output gap, meaning that the economy is in equilibrium but this equilibrium is below the potential of output. Here, there would be a role for the government to step in and push the economy back to equilibrium, where all factors of production are being fully utilised. However, because of the multiplier effect the government will not need to fill the whole of this gap with public expenditure (or taxation cuts). Suppose that there was an output gap of £10 billion and we assume that we have the multiplier of 4, the government should only increase their spending by £2.5 billion because £2.5 billion multiplied by 4 works out to be the exact amount that the economy is lacking in order to be at an equilibrium where all factors of production are being utilised. If the government had no idea that there was a multiplier effect and chose to increase their expenditure by the full £10 billion then this increase in expenditure would result in a £40 billion increase in economic activity, which is too much. This would cause the economy to experience all the problems associated with an overheating economy (all of these will be discussed later). Therefore, it is important for governments to know what the multiplier in the economy is.
Leakages
The multiplier effect also needs to be considered when looking at leakages in the economy. This is known as the reverse multiplier. Suppose a government has a deficit and they want to balance their books, they decide that they will cut government spending. This is going to take more income out of the economy than the original cut will be. Another example would be when an economy goes into a downturn and consumers stop spending (instead choosing to save more of their income), firms orders fall which means firms lay off workers, which then reduces consumption further etc… and then the economy spirals downwards because of the downwards multiplier effect on the rest of the economy. In this situation, there would be a place for government intervention.
Another point on the marginal propensity to consume is that it depends on the individual’s income level. Individuals who have a lower level of income are likely to have a higher MPC than individuals who have a higher income level. Therefore, governments should see who is affected by their potential policy and see what their MPC is.
The multiplier effect also needs to be considered when looking at leakages in the economy. This is known as the reverse multiplier. Suppose a government has a deficit and they want to balance their books, they decide that they will cut government spending. This is going to take more income out of the economy than the original cut will be. Another example would be when an economy goes into a downturn and consumers stop spending (instead choosing to save more of their income), firms orders fall which means firms lay off workers, which then reduces consumption further etc… and then the economy spirals downwards because of the downwards multiplier effect on the rest of the economy. In this situation, there would be a place for government intervention.
Another point on the marginal propensity to consume is that it depends on the individual’s income level. Individuals who have a lower level of income are likely to have a higher MPC than individuals who have a higher income level. Therefore, governments should see who is affected by their potential policy and see what their MPC is.