The Keynesian Multiplier (DP IB Economics)

An Introduction to the Keynesian Multiplier

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

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

  • Or, 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 Aggregate Demand (AD)

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

• 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 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