Th not F No S

If there is an increase in spending… … for example, if the government decides to build a new hospital in Surbiton at a cost of £500m: How much does aggregate demand increase? In pairs discuss a)Less than £500m b)£500m c)More than £500m Why?

… there will be further increases The answer is that the final increase in aggregate demand will be more than £500m This is because the increase in spending by the government will become income for others, who in turn will spend some of this income on domestic goods and services. This can be shown on the circular flow of income In this example, the £500m will be paid to a contractor to build the hospital. Aggregate demand has increased by £500m The £500m received by the contractor will in turn be paid to the factors of production – workers in the form of wages, profits to the owners, etc. Let us assume it is all paid in wages. What do the workers do with their increased incomes? Some of the extra income is saved and some is taken in tax. The rest is spent, increasing consumption. Some of the increase in spending will be on imports, but the rest will be spent on domestic goods and so represent a further, or a second round of increased aggregate demand

How big will these increases be? Do you remember marginal propensities? Recap - MPS, MPT and MPM Marginal propensity to save (MPS) measures how much of an increase in income is saved Marginal propensity to tax (MPT) measures how much of an increase in income is taxed Marginal propensity to import (MPM) measures how much of an increase in income is spent on imports These all represent withdrawals from the circular flow of income, so the total proportion of the increase in income which is withdrawn is MPS + MPT + MPM

How big will these increases be? We can call MPS + MPT + MPM the marginal propensity to withdraw (MPW), which means the proportion of the increase in income which is spent on domestic goods and services, in other words which increases AD, is 1 - MPW Let’s assume MPS is 0.1 (10%), MPT is 0.2 (20%) and MPT is 0.2 (20%) The first increase in aggregate demand is £500m How much does AD increase in the second round? The answer is £500m x (1 - MPW) = £500m x 0.5 = £250m In total AD has increased by £750m

How big will these increases be? Is that the final increase in aggregate demand? NO In our example, the workers building the hospital will spend an extra £250m on domestic goods This may include spending on food (eg at Italian Taste!), or at the local barber, or on a holiday in Cumbria The owners and workers providing these goods and services will receive a higher income. Some of this increase will be taxed, some saved, and some of the remainder spent on imports, but 50% will be spent on domestic goods, so AD increases by? £250m x 0.5 = £125m In total, AD has increased by £500m + £250m + £125m = £875m

The multiplier The multiplier is defined as the ratio of the final change in income to the initial change in spending After all the “rounds” of increased spending have finished, how much has aggregate demand (and so income) increased by? In £m, x x x etc Which comes to £1,000m, which means the multiplier is £1,000m/£500m, or 2 The general formula for the multiplier is 1/MPW So in this case 1/0.5 = 2

Use of multiplier, and its magnitude The multiplier is primarily used to calculate the impact of a change (increase or decrease) in one of the injections into the circular flow of income Changes in investment, government spending or exports If one of these items of spending changes, then the final impact on income will be greater, depending on the size of withdrawals/leakages The size of the multiplier depends on MPW, ie the marginal propensities to save, tax and import. If any of these change, the multiplier changes If the government cuts taxes so MPT is 0.15 rather than 0.2, what is the new 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 with equilibrium output increasing from Y 1 to Y 2 and the price level from P 1 to P 2 The multiplier effect is shown by the further increase in AD from AD 2 to AD 3 and so a further increase in equilibrium output from Y 2 to Y 3 and in the equilibrium price level from P 2 to P 3 Real Output SRAS Price Level AD 1 Y1Y1 P1P1 AD 2 Y2Y2 P2P2 0 AD 3 Y3Y3 P3P3

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