The Multiplier

This section explains the multiplier covering, the multiplier ratio, the multiplier process, the effects of the multiplier on the economy, understanding of marginal propensities and their effects on the multiplier and calculations of the multiplier using formulae. 

Introduction to the Multiplier

The multiplier is a key concept in Keynesian economics. It refers to the idea that an initial change in aggregate demand (AD), such as an increase in government spending, investment, or exports will lead to a greater final change in real national output and income. The multiplier effect occurs because of the continuous flow of income in the economy as people spend and re-spend money. It demonstrates how an initial injection into the economy leads to a multiplied increase in national income.

The Multiplier Ratio

The multiplier ratio is the factor by which an initial change in spending (or an injection into the economy) leads to a larger change in national income (real GDP). It measures the impact of an increase in spending on overall economic activity.

Formula for the Multiplier:
The basic formula for calculating the multiplier is:

$$\text{Multiplier} = \frac{1}{1 - \text{MPC}}$$

where MPC is the marginal propensity to consume.

This formula shows that the size of the multiplier depends on how much of any additional income is consumed (spent) rather than saved.

The Multiplier Process

The multiplier process refers to the sequence of events that takes place once an initial injection (such as government spending or an increase in exports) enters the economy:

Initial Injection: When the government increases spending or businesses increase investment, this injects money into the economy.

Increased Consumption: The initial injection increases the income of individuals or businesses, which leads to an increase in consumption as they spend part of their additional income.

Further Spending: The money spent by the initial recipients of the income then becomes income for others, who also consume part of it.

Ongoing Process: This cycle of spending and re-spending continues, although each time the amount spent decreases, as individuals save a portion of their income (determined by the marginal propensity to save, or MPS).

The process continues until the initial injection has fully worked its way through the economy, with the total increase in national income being a multiple of the initial injection.

Effects of the Multiplier on the Economy

The multiplier effect has significant impacts on the economy, both in the short and long run. The key effects are:

Increase in National Income: The multiplier effect leads to a higher level of national income than the initial increase in spending. For example, a £1 million increase in government spending can result in a larger increase in real GDP, depending on the value of the multiplier.

Economic Growth: By stimulating demand, the multiplier can help boost economic growth, especially during periods of recession or economic stagnation. It increases aggregate demand, leading to higher output, employment, and income.

Inflationary Pressure: If the economy is already close to full capacity (i.e., operating at or near potential output), the multiplier effect may lead to inflationary pressure, as higher demand for goods and services pushes up prices.

Increased Employment: As national income rises, firms respond by increasing production and hiring more workers, thereby reducing unemployment.

Regional and Sectoral Impacts: The multiplier effect may vary across regions and sectors. Areas with higher consumption or industries that benefit directly from government spending (e.g., construction during infrastructure projects) will experience larger multiplier effects.

Understanding of Marginal Propensities and Their Effects on the Multiplier

The size of the multiplier is influenced by several marginal propensities, which refer to the proportion of additional income that is either consumed, saved, taxed, or spent on imports. These include:

Marginal Propensity to Consume (MPC):

• Definition: The proportion of any additional income that a household or individual will spend on consumption.
• Effect on the Multiplier: A higher MPC means that people are spending a greater proportion of any extra income, which leads to a larger multiplier effect.

Example: If someone receives an extra £100 in income and spends £80, the MPC is 0.8, and the multiplier will be larger than if the MPC were lower.

Marginal Propensity to Save (MPS):

• Definition: The proportion of any additional income that is saved rather than spent.
• Effect on the Multiplier: The larger the MPS, the smaller the multiplier, because a higher proportion of income is being saved rather than spent in the economy.

Formula: 

$\text{MPC} + \text{MPS} = 1$, a higher MPS means a lower multiplier.

Marginal Propensity to Tax (MPT):

• Definition: The proportion of additional income that is paid in taxes.
• Effect on the Multiplier: A higher MPT reduces the multiplier because it means that less of the additional income is available for consumption. Tax increases reduce disposable income and, therefore, reduce the potential impact of any injection into the economy.

Marginal Propensity to Import (MPM):

• Definition: The proportion of additional income that is spent on imports rather than on domestically produced goods and services.
• Effect on the Multiplier: A higher MPM reduces the multiplier because more of the money spent on imports leaves the domestic economy, rather than circulating within it. This reduces the overall impact on national income.

Calculations of the Multiplier Using the Formulae

Using the formula $\frac{1}{1 - \text{MPC}}$​:

If the MPC is 0.75, the multiplier will be:

$\text{Multiplier} = \frac{1}{1 - 0.75} = \frac{1}{0.25} = 4$

This means that an initial injection of £1 million into the economy will result in a total increase in national income of £4 million.

Using the formula $\frac{1}{\text{MPW}}$​, where MPW = MPS + MPT + MPM:

If the MPS is 0.2, MPT is 0.1, and MPM is 0.15, the MPW is:

$\text{MPW} = 0.2 + 0.1 + 0.15 = 0.45$ 

Then the multiplier will be:

$\text{Multiplier} = \frac{1}{0.45} = 2.22$ 

This means that the initial injection will lead to a total increase in national income of £2.22 million for every £1 million spent.

The Significance of the Multiplier for Shifts in AD

The multiplier has important implications for shifts in aggregate demand (AD):

Government Policies: The multiplier highlights the importance of fiscal policy. For instance, an increase in government spending can have a significant impact on economic growth, depending on the size of the multiplier. A higher MPC and lower MPS, MPT, and MPM will lead to a larger shift in AD, stimulating economic activity.

Economic Stimulus: During a recession, the multiplier can help governments stimulate the economy by increasing public spending or investment. For example, if the government spends money on infrastructure projects, the multiplier effect means that this spending will lead to a larger increase in national income.

Impact of External Factors: External factors like the marginal propensity to import (MPM) can dampen the multiplier effect. In an open economy with high MPM, a significant portion of the income generated by increased spending may leak out through imports, reducing the overall impact on domestic income.

Summary

• The multiplier effect shows how an initial increase in spending can lead to a larger overall increase in national income.
• The size of the multiplier is influenced by the marginal propensity to consume (MPC), the marginal propensity to save (MPS), the marginal propensity to tax (MPT), and the marginal propensity to import (MPM).
• Higher MPC and lower MPS, MPT, and MPM lead to a larger multiplier and a bigger shift in aggregate demand (AD).
• The multiplier is crucial for understanding the effectiveness of government spending and other policy interventions in stimulating economic growth.

Key Takeaways:

• The multiplier effect amplifies the impact of initial changes in spending on the economy.
• The size of the multiplier depends on the marginal propensities: MPC, MPS, MPT, and MPM.
• Governments use the multiplier concept to design fiscal policies that stimulate economic activity, particularly in periods of recession or slow growth.

This guide will help you understand the crucial role of the multiplier in national income determination and the effects of fiscal policy on aggregate demand.