The Multiplier (Edexcel A Level Economics A)

The Multiplier

• The multiplier ratio is the ratio of change in real income to the injection that created the change

  • E.g. If the UK government injected an additional £5m into the economy through government spending and it resulted in an increase in real income of £15m, 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 benefitted from the extra consumption now have extra income

    • They spend some of that income on goods/services

    • Their expenditure on goods/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 entirely dependent on the size of withdrawals or leakages that occur during the process

    • The higher the leakages the smaller the multiplier

• The initial injection shifts AD to the right

  • The result of the multiplier process is that there is then a secondary movement of AD to the right which (if the multiplier were 2) may be double the initial movement

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

The Effects of Marginal Propensities on the Multiplier

• The 'marginal propensities' refer to the proportion of the next additional $ earned that a consumer saves, consumes, is taxed, or purchases imports with

• Marginal propensities are calculated for economies and provide insights into how each additional $ of income is allocated

  • Sweden has a higher tendency to save than the USA

    • Their marginal propensity to save is higher 

    • The USA, therefore, has a greater multiplier on any injections into the Circular Flow
      

An Explanation of The Marginal Propensities

Calculating the Multiplier

• The value of the multiplier can be calculated one of two ways

  • By focusing on the marginal propensity to consume (MPC)

  • By focusing on the withdrawals that occur on each additional $ of income (MPS + MPT + MPM)

1. Focussing on the MPC

   
   

2. Focusing on the Withdrawals

   
   

Significance of the Multiplier in Shifting AD

• The greater the withdrawals, the smaller the value of the multiplier - and vice versa

• The greater the MPC, the greater 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 and 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

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