# The multiplier

A) The multiplier ratio

This is the ratio of a change in real income to the initial injection that brought it about. For example, if a £2M injection in to the circular flow brought about by government spending caused a £4M increase in national income then the value of the multiplier would be 2. This is because the final change in national income is twice the amount of the initial injection (£2M government spending). Therefore, the definition of the multiplier is (the process by which an injection into the economy leads to an even greater change in national output than the value of the initial injection).

B) The multiplier process

The main point to remember when taking about the multiplier effect is that one person’s spending is another person’s income. For example, an injection into the circular flow such as export revenue will result in an immediate increase in AD. However, some of the money gained from selling goods/services to other countries will go to the people who made the goods/services, thus causing their incomes to increase. Some of this increased income will be spent in the economy whilst the rest will be withdrawn from the circular flow of income. The money that is not withdrawn will be spent, leading to a further increase in AD due to increased consumer spending. This second increase in AD (caused by increased consumer spending) is the multiplier effect of the initial injection. The multiplier effect can also work in the opposite way when injections decrease (a downward multiplier effect).

C) Effects of the multiplier on the economy

The effect of the multiplier can be shown using the diagram above. The initial injection (either increased government spending, investment or export revenue) causes an increase in AD (AD1 to AD2). This causes an increase in the price level (P1 to P2) and an increase in Real GDP (Y1 to Y2). However, this injection then creates income for someone else e.g. workers. Those who receive this increased income will then spend a proportion of it in the economy and the rest will be withdrawn from the circular flow. The proportion of the extra income withdrawn from the economy will determine the overall multiplier effect. This is because if less is withdrawn then more will be spent and therefore consumer spending will increase by a larger amount than if a high proportion of the money was withdrawn. The impact of the proportion of extra income spent can be seen from the formulae shown later on in the section (Calculations of the multiplier using the formulae). However, unless the proportion of the extra withdrawn is 100%, there will always be a further increase in AD/multiplier effect. This is because the proportion of extra income spent causes an increase in consumer spending which then increases AD from AD2 to AD3. The multiplier effect causes the general price level to increase from P2 to P3 and real GDP to increase from Y2 to Y3. Therefore, although the initial injection only causes an increase in Real GDP of Y1 to Y2, the multiplier means that the overall increase ends up being from Y1 to Y3. This brings the economy much closer to the full employment level (YFE).

D) Understanding of marginal propensities and their effects on the multiplier:

The marginal propensity to consume (MPC)

This is the proportion of extra income that is spent in the economy. For example, if the marginal propensity to consume was 0.6 (60% of extra income is spent), then the multiplier effect would be much larger than if the MPC was 0.4 (40% of extra income spent). This is due to the effect of MPC on the size of the increase in consumer spending that will take place from the initial injection. Therefore, the larger the MPC, the larger the multiplier is. This is a good evaluation point to make during certain macroeconomic essays e.g. (The overall effect of an increase in government spending is dependent on consumer’s marginal propensity to consume. If it is relatively low (e.g. 0.2), then the multiplier value will also be low meaning the multiplier effect will produce a smaller increase in real GDP.)

The marginal propensity to save (MPS)

This is the proportion of extra income that is saved. The bigger the MPS value is, the smaller the multiplier. This is because more of the extra income will be withdrawn from the economy rather than being kept in the circular flow of income. Therefore, the second increase in AD will be small compared to if the MPS value was small.

The marginal propensity to tax (MPT)

This is the proportion of extra income that goes to the government in the form of taxation. The larger the value of MPT, the smaller the multiplier effect will be. This is because taxation is one of the leakages in the circular flow. Therefore, the larger the proportion of extra income that gets taxed, the more of that extra income is going out of the circular flow.

The marginal propensity to import (MPM)

This is the proportion of extra income that is spent on imports. The larger the value of MPM, the smaller the multiplier effect will be. This is because instead of the majority of that extra income being spent in the economy, it will be injected into the circular flow of the country that the domestic consumer is spending their extra income buying imports from.

E) Calculations of the multiplier using the formulae

The multiplier value can be calculated using either the Marginal propensity to consume or the Marginal propensity to withdraw. Although they are both different formula, they both give the same answer/multiplier value. The marginal propensity to withdraw value is made up of the withdrawal components in the circular flow of income (Marginal propensity to save + Marginal propensity to tax + Marginal propensity to import). Therefore the marginal propensity to withdraw shows us how much of that extra income is going out of the circular flow of income. On the other hand, MPC represents the amount of extra income that is spent. For example, if a consumer gained £100 in extra income and decide to spend £50 of it, their MPC would be 0.5. This is because they’re spending 50% of their extra income. As 1 represents 100% of that extra income being spent, 1-MPC shows us how much of that extra income didn’t stay in the circular flow/was withdrawn (MPW).

Marginal propensity to withdraw = Marginal propensity to save +Marginal propensity to tax + Marginal propensity to import

F) The significance of the multiplier for shifts in AD

As shown from the following examples, the greater the marginal propensity to consume, the greater the multiplier effect and therefore the greater the increase in AD.

Example 1 (Average MPC value):

Government spending = £100M