The Keynesian Multiplier (DP IB Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
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
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Marginal Propensity to Consume (MPC) |
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Marginal Propensity to Save (MPS) |
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Marginal Propensity to Tax (MPT) |
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Marginal Propensity to Import (MPM) |
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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)
Focussing on the MPC
Focusing on the Withdrawals
Worked Example
An economy has the marginal propensity to save of 0.15, marginal propensity to tax of 0.20 and a marginal propensity to import of 0.15.
a) Calculate the size of the multiplier.
b) If the Government increases their infrastructure spending by £60m, calculate the total increase in GDP, assuming all other things remain equal.
Answer:
Step 1: Insert the values into the withdrawal formula
Step 2: Multiply the injection by the multiplier
Impact on GDP = Injection x multiplier
= £60m x 2
= £120m
Worked Example
Calculate the amount of government spending required to restore an economy's macroeconomic equilibrium if the economy faces a $22bn recessionary gap and its MPC is 0.6 [2]
Answer:
Step 1: Calculate the multiplier
[1 mark]
Step 2: Calculate the value of government spending required
[1 mark]
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
Examiner Tips and Tricks
The final bullet point above mentions time lags. This is an excellent point to include in any evaluation on the effectiveness of the multiplier. It may take up to 18 months for the full multiplier effect to be seen & any change to consumer confidence during this period will impact the final outcome.
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