The Multiplier & Basic Accelerator Process (AQA A Level Economics)

The Influence of AD on the Level of Economic Activity

• Aggregate demand (AD) is a major determinant of overall level of output (GDP) and employment in the economy

Diagram: The Influence of AD on Real GDP

Diagram analysis

• When an injection occurs in the economy, such as through increased government spending or investment, the AD curve will shift to the right (AD₁ to AD₂)

  • This increases the overall level of real output 

  • When real output increases, firms typically need to hire additional workers to meet the higher demand for goods/services 

  • The increased employment is linked to an increase in economic growth 

• When a withdrawal occurs in the economy, such as through more taxes or spending on imports, the AD curve will shift to the left (AD₁ to AD₃)

  • This decreases the overall level of real output 

  • When real output decreases, firms typically reduce their workforce to align with reduced  demand for goods/services 

  • The decreased employment is linked to a decrease in economic growth 

The Multiplier

• The multiplier states that any injection in the economy leads to a greater impact on the economy than the value of the initial injection

  • E.g. If the Brazilian government injected an additional 5bn Brazilian real (BZL) into the economy through government spending, it may lead to an increase in real income of 15bn BZL

    • In this example, the value of the multiplier would be 3

• The multiplier process is based on the idea that one individual's spending is another individual's income

  • An increase in consumption immediately increases AD

    • Store owners who have benefited from the extra consumption now have extra income

    • They spend some of that income on goods and services

    • Their expenditure on goods and services is now income for the next tier of individuals 

• Due to the successive rounds of spending, the final increase in national income is much larger than the initial injection
   

• The size of the multiplier is influenced by the size of leakages that occur during the process

  • The higher the leakages, the smaller the marginal propensity to consume (MPC)

  • The higher the marginal propensity to consume, the lower the leakages and the greater the multiplier will be 

• The marginal propensity to consume (MPC) is the proportion of additional income that is spent on consumption (C) 

Diagram: The Effect of the Multiplier

Diagram analysis

• The initial injection shifts AD to the right, from AD₁ to AD₃

• The result of the multiplier process is that there is then a secondary movement of AD to the right, from AD3 to AD2

  • If the multiplier were 2, this would double the initial movement

• The multiplier can also work in reverse when injections are reduced (downward multiplier effect)

Calculating MPC & The Multiplier

• Marginal Propensity to Consume (MPC) is the proportion of additional income that is spent on consumption (C)

  • It can be viewed as how many pence is spent by households on consumption from every additional £1 of income

  • It can be calculated using the formula

• The value of the multiplier can be calculated by using the formula

• The greater the MPC, the higher the value of the multiplier, and vice versa
  

• Any change in one of the factors that impacts on disposable income will change the multiplier

  • If taxes increase, the value of the multiplier reduces

  • If interest rates increase, savings increase, consumption decreases and the multiplier reduces

  • If exchange rates appreciate, the level of imports will increase and the multiplier decreases

  • If confidence in the economy increases consumption increases and the multiplier increases 

• It is extremely useful for the Government to know the value of the multiplier

  • They can use it to judge the likely economic growth caused by increased spending

  • The bigger the MPC, the greater the multiplier effect will be 

• There is a time lag as it takes time for the successive rounds of income to work through the economy

The Basic Accelerator Process

• The accelerator process suggests that changes in the level of investment from firms (into capital goods such as machinery, factories, etc) are necessary to meet the changes in the overall level of economic activity

  • As economy expands, firms invest more into capital goods

  • As economy contracts, firms invest less into capital goods

• The accelerator process highlights the cyclical relationship between investment and the [popover id="DB2eSi2-4aBs15y~" label="economic cycle"]
   

• The multiplier and the accelerator process work together 

  • As the demand for goods and services increase, AD increases 

  • As a result, firms invest more (or make an accelerated investment) into capital goods to meet demand for products in the hope of making a profit

  • This leads to a further increase in AD

  • This increase in AD is then multiplied, making growth in national income more rapid

  • Which leads to an even more accelerated investment into capital goods by firms

• The accelerator process and multiplier effect can also occur in the opposite direction 

  • If the economy contracts (during a recession), demand for goods and services will fall 

  • Firms invest less in capital goods

  • Which then leads to a negative multiplier effect