Multiplier

The Multiplier: Changes in Expenditure

Shifts in AE curve changes income.

The following events would result in a higher level of AE – the AE line in the model would shift upwards at all levels of disposable income:

• A rise in retail spending due to an increase in consumers confidence : Component?
• An increase in wheat exports to the middle east
• An increase in business investment associated with new clean energy projects

Multiplier Effect:

• ‘one mans’ spending is another man’s income’
  • Make sure to describe this in your own words (elaborate when mentioning it)
  • Consumption have knock on effects, resulting in increase income that is greater than the initial amount spent.

E.G. Initially, we assume our economy has just 3 sectors - households, firms and the financial sector - Aggregate expenditure therefore consists of consumption + investment

• Assume a mining company decides to spend $10 billion to develop a mine site and rail link in Western Australia.
• The initial (new) investment creates income for contractor firms and their employees, including engineers, architects and construction workers.
• These people (households) will then spend part of that income on goods and services including food, clothing rent and entertainment
• This spending will flow on to other people in the economy through the circular flow of income.
• The final impact of the new spending is likely to be much greater than the initial value of the project

The multiplier refers to the proportion by which income will rise following an initial change in spending

• If an increase in investment of 10 billion dollars caused the level of income to rise by 25 billion dollars, the value of the multiplier would be 2.5 that is - the final impact on income is 2.5 times the new investment.
• The following example shows the multiplier at work and how the marginal propensity to consume determines its final impact

Definition: The MULTIPLIER is the amount by which real income or GDP changes after an initial change in expenditure.

Need MPC and MPS to calculate your multiplier

Multiplier Formula:

\[k = ΔS/ΔY\]

and also the value of the multiplier is determined by the marginal propensity to consume and can be derived from the formula:

\[k = \frac{1}{1-MPC} = \frac{1}{MPS}\]

What if MPC increases: This would increase the ‘re-spending’ effect from a given change in investment and so the value of the multiplier must rise.

• Small changes in the MPC can have a dramatic effect on the size of the multiplier, as shown in the sidebar
• As the MPC increases (MPS decreases), the multiplier increases.

The Graph

The business cycle can be modelled using the Keynesian aggregate expenditure model. Falls in AE bring about a contraction, as growth in real GDP slows from Yf to Yd. Rises in AE, on the other hand, are associated with an expansion - growth in real GDP increases from Yf to Yi.

The level of income in the economy expands in successive rounds of new spending which generates new income via the marginal propensity to consume.

• Alternate (For negative multiplier effect): This phenomenon is called the negative multiplier effect, where any change in autonomous components in AE result in larger changes in income through successive rounds of reduced spending which generate reduced new income via the marginal propensity to consume.

A change in the autonomous component of AE results in larger change to income

There are many instances in which the multiplier principle would have an impact on the Australia economy.

• Remember that the multiplier process applies to any autonomous (not influenced by income) change in expenditure – which could be a change in investment, government spending or exports (NOT CONSUMPTION)
• Examples include:
  • Resource projects in the Pilbara region of WA;
  • An increase in government spending on new railways; and
  • **The increase in the Jobseeker allowance during the pandemic
  • The increase in apartment construction in capital cities

If investment falls the level of income in the economy will fall by a greater amount

• Negative Multiplier Effect
• The closure of a bank in a rural town would have a ripple effect on other services as bank employees moved, supermarket turnover would fall, as would café sales, doctors visits and so on.
• On a wider scale, the global financial crisis (GFC) in 2008-09 and the pandemic in 2020 both led to a fall in investment spending and a fall in GDP in Australia….slowing growth and increasing unemployment.

Size of the Multiplier

• The size of the multiplier is determined by the factors that affect the marginal propensity to consume
• If the MPC is greater than zero but less than one, the multiplier will have a value greater than one Is there an upper limit to the multiplier?
• The extent of the multiplier will be influenced by the size of leakages associated with savings, taxation and imports
• Each of these leakages reduces the size of the multiplier

Is there an upper limit to the multiplier?

• If the MPC was equal to one, then the multiplier would equal infinity.
• In reality there are a number of factors which restrict the value of the MPC and therefore reduce the size of the multiplier.

When these are taken into account the formula for the multiplier equation looks slightly different:

\[K = \frac{1}{(MPS + MPT + MPM)}\]

MPS = marginal propensity to save MPT = marginal propensity to tax MPM = marginal propensity to import

Estimates show that while it varies over the course of the business cycle, its average value is between 1.5 and 2.5

Multiplier effect is usually used for policy targeting.

In general:

• Any autonomous increase in one of the components of AE will be multiplied to result in a higher level of real GDP
• Any autonomous decrease in a component of AE will be multiplied to result in a lower level of real GDP