The multiplier effect

The multiplier effect M.K positives of gov spending money. Question: If the government decided to increase spending, let's say on a particular infrastructure project costing 100 billion pounds, what do you think the final effect on GDP would be? (a) greater than £100bn (b) less than £100bn (c) exactly equal to £100bn Answer: The final effect on GDP of the extra £100bn of government spending would be greater than £100bn. Why? This is due to what economists call the multiplier effect. Government spending boosts the economy by more than what is spent the government increases spending during a recession Iry building new infrastructura, for example, wil Thái apending wit iccrasse demand and croate employment. The newly exploys workers will save some of then income, and spend the rest The multiplier effect explained Let's say the government spends £100hn on a new High Speed Rail system. Some of the £100bn would end up going to the architects, engineers, builders, electricians and designers. Some of the £100bn would end up going to the providers of the capital and raw materials such as concrete, steel and electricity, so the £100bn ends up as income in the pockets of many people who provided the factors of production (mainly land, labour and capital) for the rail project. 1 Page But the money does not stop there. Those initial recipients of this income are likely to spend it, so that it ends up going to another group of people, in exchange for food and clothing, leisure activities and a host of other goods and services. And, indeed, it won't stop there either. The money will continue moving around the economy, in many successive rounds of spending, benefiting many people far removed from the initial recipients of the £100bn from the government. Just like the ripples on a pond! withdral Indeed, if there were no taxes, no money spent on imports and no savings, that money would keep on moving around the circular flow endlessly. So, every pound spent by the government would have an infinite effect on GDP. unft impract i negust. What would happen in the opposite case, if the multiplier was equal to 1? But, neither of these cases is likely. It is more probable that with each round of spending some that money is withdrawn from the circular flow, either in the form of taxes, savings or money spent on imported goods and services which will end up abroad. [You will remember that the three withdrawals to the circular flow are Savings, Imports and Taxation.] So, with each round of spending, the initial 100bn will get a little smaller as a proportion is spent on withdrawals and the rest carries on around the circular flow as consumption. 1000円 Savings Imports Taxation After the initial injection of £100bn from the government, some money gets withdrawn from the circular flow with each successive round of income and spending. Until the amount of the initial £100bn that is left is negligible. But, even though each round of spending and income gets smaller, when you add up all the rounds of diminishing size, you end up with more than the initial £100bn, so, 2 Page you can see why the final effect on GDP of the initial £100bn will be greater than £100bnl Each time the money flows around the economy, it is benefiting individuals by adding to their income/consumption and therefore increasing GDP a little more. But how much greater will the final effect on GDP be? This will depend upon how much money at each round of spending gets withdrawn and how much continues round the circular flow. The more that gets withdrawn, the less is left in the circular flow to benefit the economy and therefore the smaller the final effect on GDP. And vice versa. Lava nee an illustrativa suample in thie svamplo un nesume that anac of income ic withdrawn at each round of spending, and 60% remains in the circular flow to be re- spent. The multiplier in practice Initial spending by government in Ebn = 60% of 100 100 2nd round of spending 60.00 3rd round of spending = 60% of 60 36.00 4th round of spending = 60% of 36 21.60 5th round of spending 60% of 21.60 12.96 6th round of spending Etc... 7.78 7th round of spending 4,67 8th round of spending 9th round of spending 2.80 1.68 10th round of spending 1.01 11th round of spending 0.60 12th round of spending 0.36 13th round of spending 0.22 14 round of spending 0.13 15th round of spending 0.08 16th round of spending 0.05 17th round of spending 0.03 18th round of spending 0.02 19th round of spending 0.01 20th round of spending 0.01 Total spending including initial spending by govt £249.99bn In this example, after 20 rounds of spending, the amount of the initial £100bn left in the circular flow is quite small, so we've stopped the rounds there. By adding up all the spending in each round we can see that the final increase in GDP from the initial £100bn is around £250bn. That is, the initial £100bn has effectively been multiplied up to £250bn. In this case we would say that the value of the multiplier is 2.5. Here we assumed that 40% of income is withdrawn at each round of spending, and 60% remains in the circular flow to be re-spent. What would happen if 60% of the Income was withdrawn at each round and 40% was re-spent? What would you expect to happen to the size of the multiplier? 3 Page The Multiplier - Definition The ratio of a change in equilibrium real GDP to the autonomous change that brought it about. What is the value of the multiplier in the UK? Co-incidentally, estimates of the UK's multiplier vary between 1 and 3. This is similar to other OECD countries such as the US. There are many factors that affect the size of the multiplier in practice, and so it is difficult to estimate with accuracy. One factor that can cause the multiplier to change is the business cycle. Research from the IMF has shown that multipliers tend to be smaller in an expansion, with fiscal stimulus having a smaller expansionary effect on GDP than in a downturn. To a certain extent, this echoes what we already know about the effects of an increase in AD at different parts of the Keynesian AS curve. How to calculate the multiplier We have already mentioned the relationship between the size of the withdrawals from the circular flow and the size of the multiplier. As we have already said the larger the withdrawals, the smaller the multiplier would be, as less money would be left in the circular flow, to continue benefiting the economy. So, we would say there is an inverse relationship between the size of withdrawals and the size of the multiplier. We can formalise this relationship in the following way: The Multiplier = 1 MPW Where MPW = the marginal propensity to withdraw The marginal propensity to withdraw is the proportion of any extra income that is withdrawn from the circular flow. So, if I earn an extra E1 and spend 80p on consumption, the rest is 'withdrawn' in the form of taxes, savings or spending on imports. Therefore, my MPW would be 0.2. If my MPW was 0.2, what would be the size of the multiplier? The Multiplier ==5 1 MPW is our first formula for the multiplier. There are two others which you need to know which can easily be derived from this. 4 Page