An initial change in aggregate demand can have a much greater final impact on the level of equilibrium national income. This is known as the multiplier effect
It 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
What is a simple definition of the multiplier?
It is the number of times a rise in national income exceeds the rise in injections of demand that caused it
Examples of the multiplier effect at work
- 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.
The Multiplier and Keynesian Economics
- The concept of the multiplier process became important in the 1930s when John Maynard Keynes suggested it as a tool to help governments to maintain high levels of employment
- This “demand-management approach”, designed to help overcome a shortage of capital investment, measured the amount of government spending needed to reach a level of national income that would prevent unemployment.
The value of the multiplier depends on:
- Propensity to import
- Propensity to save
- Propensity to tax
- Amount of spare capacity
- Avoiding crowding out
- 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.
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
Time lags and the multiplier effect
- It is important to remember that the multiplier effect will take time to come into full effect
- A good example is the fiscal stimulus introduced into the US economy by the Obama government. They have set aside many billions of dollars of extra spending on infrastructure spending but these capital projects can take years to be completed. Delays in sourcing raw materials, components and finding sufficient skilled labour can limit the initial impact of the spending projects.
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 in developed nations have been introducing fiscal austerity programmes – 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)
Calculating the value of the multiplier
The formal calculation for the value of the multiplier is
Multiplier = 1 / (sum of the propensity to save + tax + import)
Therefore if there is an initial injection of demand of say £400m and
- The marginal propensity to save = 0.2
- The marginal rate of tax on income = 0.2
- The marginal propensity to import goods and services is 0.3
Then the value of national income multiplier = (1/0.7) = 1.43
An initial change of demand of £400m might lead to a final rise in GDP of 1.43 x £400m = £572m
- The marginal propensity to save = 0.1
- The marginal rate of tax on income = 0.2
- The marginal propensity to import goods and services is 0.2
The value of the multiplier = 1/0.5 = 2 – the same initial change in aggregate demand will lead to a bigger final change in the equilibrium level of national income.