The Multiplier Flashcards
What is the multiplier effect?
The effect of an injection into an economy; one person’s expenditure becomes another’s income, again and again and again, until it has all leaked out of the circular flow of income.
Explain the multiplier effect (3).
1) The government invests £10m in subsidies to firms, which is used by firms to invest in capital stock, e.g. machinery and factories, and expand production. This expenditure flows to households as income.
2) Only £9m of this income is spent, as the other 10% leaks out as savings, imports and taxation. Consumption flows from households into firms, and back to households as profit and wages, with 10% leaving the economy again through withdrawals. Consumption becomes £8.1m in the economy.
3) The process continues with smaller and smaller amounts being added to national income. The total value of the multiplier of the initial £10m investment and a 10% leakage is £100m - a multiplier of 10.
What is the marginal propensity to consume (MPC)?
The proportion of each extra pound earned that is spent on consumption.
How is MPC calculated?
Change in consumption / change in income.
How can MPC be used to calculate the multiplier?
Multiplier = 1 / 1-MPC
E.g. If MPC = 0.9
1 / 1-0.9
=1 / 0.1
= 10
Why is the value of the multiplier important?
It helps the government to estimate the impact on AD of any investment in the economy. If MPC is 90%, then the multiplier ration is 9:1, as the 10% not spent becomes a withdrawal, not contributing to consumption or AD.
What is the marginal propensity to withdraw (MPW)?
The proportion of extra income that is withdrawn from the economy.
What are the 3 components of marginal propensity to withdraw?
1) Marginal propensity to save (MPS): The proportion of an increase in income that is saved.
2) Marginal propensity to tax (MPT): The proportion of an increase in income that is taxed.
3) Marginal propensity to import (MPM): The proportion of an increase in income that is spent on imports.
MPW = MPS + MPT + MPM
Why does MPC + MPW = 1?
As all additional income must either be spent or withdrawn.
What impact does an increase in the value of MPW have on the multiplier?
The greater the value of MPW, the smaller the impact of the multiplier on AD.
What are some influences on MPS (3)?
1) Economic forecasts.
2) Consumer confidence.
3) Interest rates.
What are 5 influences on MPM?
1) Business/consumer confidence.
2) Anticipated income and wealth.
3) The exchange rate.
4) Availability of domestic goods.
5) Government policy regarding protectionism.
How is the multiplier calculated using MPW?
Multiplier = 1/MPW
E.g. if MPW = 0.1
=1/0.1
=10
How is the change in real GDP and initial change in spending used to calculate the multiplier?
Change in real GDP / Initial change in spending
E.g. If an initial investment of £5 billion led to a change in real GDP of £20 billion, then the multiplier = 4.
What are, and explain, the factors that influence MPW (7)?
1) Interest rates: The higher the interest rate, the higher MPS, as borrowing is more expensive and saving is incentivised.
2) Household wealth: The wealthier the household, the more likely they are to spend, due to the wealth effect.
3) Exchange rates: The stronger the pound, the higher the MPM, as more can be bought.
4) The quality/availability of imports: If imports are of low quality/availability, the lower the MPM. Vice versa.
5) The rate of direct and indirect taxes: The higher the rate of direct and indirect taxes, the higher the MPT.
6) Economic performance: If the economy is in a recession, spending will be low, so MPS will be higher.
7) Consumer/business confidence: The less confident economic agents are, the less likely they are to spend/invest, instead saving.
