Topic 1.5 - The Multiplier And Accelerator

Question 1

What is the national income multiplier?

Answer 1

Process by which any change in a component of AD results in a greater final change in real GDP (injection into circular flow)

Question 2

What causes the effects of the multiplier to be diluted?

Answer 2

Spending allows multiplier effects to be perpetuated
Households with extra income will not spend all of it - effects diluted
Injections into circular flow can initiate multiplier effects but leakages determine the size of the effect

Question 3

What factors determine the size of the multiplier?

Answer 3

How much of national income is:

• saved by households
• returned to government through direct tax
• spent on imports

Question 4

What is average propensity to consume?

Answer 4

Proportion of income spent on consumption

= consumption/income

Question 5

What is the average propensity to save?

Answer 5

Proportion of income saved

=savings/income

Question 6

What is the average propensity to tax?

Answer 6

Proportion of income spent on tax

=tax/income

Question 7

What is the average propensity to import?

Answer 7

Proportion of income spent on imports

=imports/income

Question 8

What is the average propensity to withdraw?

Answer 8

Proportion of income spent on withdrawals - savings, taxes and imports
= withdrawals/income
APW = APS+APT+APM

Question 9

What is the marginal propensity to consume?

Answer 9

Proportion of any change in income spent on consumption
MPC = change in consumption/change in income
MPS = change in savings/change in income
MPW = change in withdrawals/change in income (bigger multiplier - smaller MPW, more money, less flows out of circular flow)

Question 10

How can we work out the size of the multiplier?

Answer 10

We assume that half of any additional expenditure and therefore income leaks out then half must spark off extra spending

Question 11

What is the multiplier formula?

Answer 11

K (multiplier) = 1/MPW (MPS+MPT+MPM)

Question 12

Show the multiplier effect on a neoclassical diagram

Answer 12

Question 13

Show using a diagram the multiplier effect on a Keynesian diagram

Answer 13

Question 14

What is the accelerator theory?

Answer 14

Increase in national income (GDP) results in a proportionally larger rise in capital investment
Often see a large surge in capital spending by businesses when an economy is growing strongly (increase in demand, component increasing)
Principle states, given change in demand for consumer goods will cause a greater percentage change in demand for capital goods

Question 15

How does the accelerator come about?

Answer 15

• demand rises at a strong pace
• firms respond by expanding production and making fuller use of their existing productive capacity
• if they feel demand is sustained, may choose to increase spending on capital goods to increase capacity
• demand for capital goods driven by demand for products supplied by firms
  Examples:
• extra capacity for iCloud computing storage
• investment in 4g
• investment in renewable energy as supply shifts to renewable

Question 16

How does the accelerator and multiplier interact with each other?

Answer 16

If output increases following an increase in AD
An increase in investment has a multiplier effect that induces an additional increase in AD
They reinforce each other
Can happen in reverse, output slows leading to fall in investment and negative multiplier effects
Fluctuations in economic cycle

Question 17

Accelerator diagram - neoclassical

Answer 17

Question 18

What are output gaps?

Answer 18

Difference between the actual level of real GDP and the full employment level
External shocks can cause real GDP to be above or below YFE
Can be both positive and negative

Question 19

Using a diagram show negative output gaps in Keynesian and neoclassical assumptions

Answer 19

Question 20

Show positive output gap on a neoclassical model

Answer 20

In neoclassical assumption, the economic always moves back to YFE so no output gap remains in long run, only in short run
Image shows negative output gap (ignore writing on image)

Question 21

Positive and negative output gaps on a PPC

Answer 21

Question 22

What are the consequences of positive output gaps?

Answer 22

Only possible in short run
Unsustainable in long run
Puts pressure on FOP
Will lead to an increase in price level - makes economy less competitive, sell less exports
Long run full employment unlikely to change

Question 23

What are the consequences of negative output gaps?

Answer 23

Possible in short run and long run (Keynesian)
Falling outpu
Unemployment - waste of resources
Slowing economic growth
Possible downward pressure on price level
Consequences more significant under Keynesian assumptions compared to neoclassical views

Question 24

For the Keynesian model, the overall consequences depend on…

Answer 24

Reason for falling AD (temporary short external shock or permanent lasting damage caused by recession)
If permanent we could end up in a position with persistent negative output gap, resulting in unemployment and low economic growth

Overall, depends on whether change in AD is permanent or temporary + shape of LRAS curve and speed at which economy is able to readjust back to equilibrium