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
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 value of the multiplier depends on:
In short – the multiplier effect will be larger when
Time lags and the multiplier effect
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
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 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.
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