The Multiplier The number of times a rise in GDP exceeds the rise in injections that caused it. Eg. if £10M increase in net injections results in £10.4 increase in GDP then the multiplier is 1.4

The Multiplier Injections of new demand for goods and services into the circular flow of income stimulate further rounds of spending – “one person’s spending is another’s income”. This leads to a bigger eventual effect on output and employment as the money is circulated around the economy. The larger the multiplier, the larger the effect on the economy of an injection. Formula based on how much of £1 extra will be re-spent in the economy – any money not re-spent is ‘leaked’ and so doesn’t go round the circle again. The % re-spent is the ‘Marginal Propensity to Consume.’ Eg. If we tend to re-spend 70% of what we earn, MPC is 0.7.

The Multiplier Example: If MPC = 0.6, then out of each injected £1, £0.60 will be re-spent, and so on So, total GDP will rise by: £1 + £ £ £ £ £ £0.05 …

Consider a £300 million increase in capital investment – eg. an overseas company decides to build a new production plant in the UK. This sets off a chain reaction of increases in expenditures. Firms who produce the capital goods and construction businesses who win contracts to build the new factory will see an increase in their incomes and profits. If they and their employees in turn, collectively spend about 3/5 of that additional income, then £180m will be added to the incomes of others. At this point, total income has grown by £300m + (0.6 x £300m). The sum will continue to increase as the producers of the additional goods and services realize an increase in their incomes, of which they in turn spend 60% on even more goods and services. The increase in total income will then be £300m + (0.6 x £300m) + (0.6 x £180m). Each time, the extra spending and income is a fraction of the previous addition to the circular flow. The Multiplier

How much is leaked or ‘withdrawn’ from the economy determines the size of the multiplier. – MPS = Marginal propensity to save (MPS) measures the proportion of an increase in income is saved – MPT = Marginal propensity to tax measures the proportion of an increase in income taken in tax – MPM = Marginal propensity to import the proportion of an increase in income spent on imports These are the “withdrawals” from circular flow The total proportion of an increase in income that is withdrawn: MPW = MPS + MPT + MPM How to Calculate The Multiplier

The multiplier = 1/MPW So, if: MPS is 0.1 (10%) MPT is 0.2 (20%) MPM is 0.2 (20%) Then MPW is 0.5 (50%) So, the multiplier = 1/0.5 = 2 If AD is increased by an initial injection of £100m, the final increase in AD will be £200m How to Calculate The Multiplier

The multiplier = 1/MPW MPW = 1 – MPC (marginal propensity to consume) So, the multiplier is also 1 / 1-MPC If MPC = 70% or 0.7 Multiplier = 1 / = 1 / 0.3 = 3.33 If AD is increased by an initial injection of £100m, the final increase in AD will be £333m How to Calculate The Multiplier

The multiplier on an AD/AS diagram The initial increase in aggregate demand from building the hospital is £500m and is represented by a shift from AD 1 to AD 2 The multiplier effect is shown by the further increase in AD from AD 2 to AD 3 and then to AD 4 Notice that successive shifts are smaller and smaller as money is leaked out with every trip round the circular flow Real Output SRAS Price Level AD 1 Y1Y1 P1P1 AD 2 Y2Y2 P2P2 0 AD 3 Y3Y3 P3P3 AD 4 Y3Y3 P4P4

Examples Calculate the value of the multiplier and the change in income if: 1.Animal spirits rise leading to an increase in investment of £2 billion. MPW is Chinese economy collapses, so exports fall by £1.5 billion. MPS is 0.1, MPT 0.1 and MPM is The government wants to reduce the deficit, so cuts government spending by £1 billion. Savings rate is 10%, MPT is 25% and MPM is 25% What happens to the multiplier if: 4.MPW was 0.6, but new pension rules means the savings rate increases from 5% to 15% 5.Government reduces taxes so MPT falls from 0.25 to 0.2. Old MPW was 0.6