2.2 E The Multiplier Effect
for HL eyes only
B & D pages 199 – 201
THE MULTIPLIER EFFECT
(revise the circular flow model to understand it)
Definition: When an injection occurs in the
economy, the change in GDP will be much larger
than the injection which caused it.
An initial rise in income sets off a “chain reaction”
(as demonstrated in the circular flow model) of
income-expenditure which gives rise to a larger
increase in national income (GDP).
Task 1: illustrate how this works using a) the
circular flow model and b) the ASAD model
The effect arises because when revenue is received by
firms, this is passed onto households as income, and part
of that income is passed on to other firms in the form of
spending, and this results in income for further
households, who pass on part of this income to yet more
households.
The Multiplier Effect...
Price
Level
2. …but the multiplier effect can amplify
the shift in aggregate demand.
$20 billion
AD3
1. An increase in government
purchases of $20 billion
initially increases aggregate
demand by $20 billion…
0
AD2
Aggregate demand, AD1
Real Output
MPC: the marginal propensity to consume
 An initial injection won’t endlessly circulate in an
economy; there are leakages all along the way.
Thus there is a proportion that is withdrawn. If
we consider the flow of income into households,
some money is taxed and some is saved. The
marginal propensity to consume (MPC)
therefore, is the proportion of the additional
income that is spent by households.
 MPC = ΔC/ ΔY
 Task 2: What is MPS?
Task 3: How is MPC is affected by:
1.
2.
3.
4.
Interest rates
Employment Expectations
Price Expectations
And also The Life-Cycle Hypothesis –
suggests that consumer spending/saving is
partly dependent on the stage of the life cycle
Young wage earners – no responsibilities – save little
Young partners – save hard to set up home (nest)
Full nest – little is saved due to cost of raising a family
Empty nest – parents can save for old age
How can we find out how much more
the national income increases?
Task 4: Suppose the MPC is
0.8 and the level of
investment increases by 125.
Initially, the households who
receive this investment
spending will receive this
income, and then the multiplier
process will be set in motion
ΔY
ΔC
(0.8Y)
ΔS
(0.2Y)
125
100
25
100
80
20
80
64
16
64
51.2
12.8
And so on until
it ends
total
625
A simpler way is to use the Multiplier
It’s given, or can be calculated from the MPC:
The multiplier = 1/(1-MPC)
or alternatively = 1/MPW
Total increase in GDP (Y) = Initial increase x 1/(1 – MPC)
In this case, this equals
125 x 1/(1 – MPC)
= 125 x 1/0.2
= 125 x 5
= 625
Simple multiplier Questions
 If the MPC is 0.6, calculate the value of the
multiplier
 If people save 0.25 of their income, calculate the
value of the multiplier
 If the MPC is 0.9, and Investment increases by
300, what effect will this have on national
income?
 If the MPS is 0.2, and national income is 600,
calculate the new national income if investment
falls by 50
The multiplier in a 4-sector, open economy
 Now we can add in all withdrawals in the 4-sector
economy.
 Thus MPW = MPS + MPT + MPM, will so the
value of the multiplier will be smaller.
The value of the multiplier will be 1/(s + t + m)
 Where s is the marginal propensity to save
 t is the marginal propensity to tax
 m is the marginal propensity to import
Task 5: IB Multiplier Questions
 In an open economy with a government sector,
s = 0.1, t = 0.1 and m = 0.05.
 Calculate the value of the multiplier
 In the above economy, investment increases by
$600. What effect will this have on the
equilibrium level of national income?
 If the government wishes to increase national
income by $1200 (by increasing government
spending) by how much will it need to increase
government spending?
Not in the IB syllabus (but used to be):
Accelerator Theory
 The accelerator theory suggests that the level of
induced investment will be determined by the
rate of change of national income.
 When national income is rising, then firms will
want to meet increasing demand by expanding
their capacity, and investment will rise more
rapidly – i.e. accelerates.
 The combined accelerator-multiplier effect can
help explain the upward momentum of the
business cycle.
 The reverse is true for the downward part.