The Multiplier

Question 1

What is the multiplier effect?

Answer 1

The multiplier effect occurs when an initial injection into
the circular flow causes a bigger final increase in real national income.
This injection of demand might come for example from a rise in exports
X, investment I or government spending G.

Question 2

Explain how the multiplier effect works

Answer 2

The multiplier effect arises because one agent’s spending is another
agent’s income. When a spending project creates new jobs for
example, this creates extra injections of income and demand into a
country’s circular flow.

Question 3

What is the negative multiplier effect?

Answer 3

The negative multiplier effect occurs when an initial withdrawal or
leakage of spending from the circular flow leads to knock-on effects
and a bigger final drop in real GDP

Question 4

How do you find the multiplier coefficient?

Answer 4

The multiplier coefficient itself is found by:
Final change in real GDP / Initial change in AD

Question 5

What is the multiplier formula?

Answer 5

Multiplier k = 1/(1 - MPC) where the MPC = the marginal propensity to consume

Question 6

What is MPC?

Answer 6

the proportion of a raise that is spent on the consumption of goods and services, as opposed to being saved.

Question 7

What are other multiplier formulae for a closed economy with and without a govt and an open economy with a government?

Answer 7

In a closed economy with no government: k = 1/MPS
In a closed economy with a government k = 1/(MPS + MPT)
In an open economy with a government k = 1/(MPS + MPT + MPM) or 1/MPW

Question 8

What are factors that have high multiplier value?

Answer 8

• Economy has plenty of spare capacity
• Propensity to import and tax is low
• High propensity to consume any
  extra income

Question 9

What are factors that have low multiplier value?

Answer 9

• Economy is close to full capacity
• Rising demand causes inflation
• Higher inflation causes rising
  interest rates

Question 10

Show the multiplier effect in a diagram.

Answer 10

Initial increase in AD from AD1 to AD2
increases real GDP from Y1 to Y2.
It then kicks off a multiplier effect which
increases AD further to AD3 and real GDP rises to Y3

Question 11

What are the drawbacks of multipliers?

Answer 11

• Difficult to know exact size of multiplier - hard to measure
• Takes time for multiplier process to feed through to real GDP – time lag
• Economists disagree over its size
• Long run multiplier effect is likely higher for developing economies than for
  developed ones; infrastructure projects often have higher multiplier effects