Multiplier Effect

 
 

Multiplier Effect

The multiplier effect is the extent to which an increase in AE results in a larger, multiplied increase in NY. The multiplier process shows that the equilibrium level of income will increase when there is an increase in any of the autonomous components of AE (C, I, G, (X-M)). The increase in NY will be greater than the increase in AE due to the multiplier effect. 

By the end of this chapter, students will understand how the multiplier effect impacts an economy’s actual and potential growth, as well as the consequences of underemployment and resource underutilization. We will also examine trade-offs involved in economic decision-making, using real-world examples to make these concepts easier to grasp.

1. Understanding the Multiplier Effect

1.1 What is the Multiplier Effect?

The multiplier effect refers to how an initial increase in spending creates a ripple effect, leading to a greater total impact on national income. This happens because spending by one person or entity becomes income for another, which is then spent again in successive rounds.

Real-World Example: COVID-19 Stimulus in Singapore

During the COVID-19 pandemic, Singapore’s government introduced the SGD 100 billion Resilience Budget to support businesses and workers. This included cash transfers and wage subsidies. When recipients spent this money on goods and services, businesses earned higher revenues, allowing them to hire more workers or invest further, leading to additional rounds of spending.

Imagine the Singaporean government injects $1 billion into the economy through increased infrastructure spending. This initial injection creates new income for construction workers, engineers, and other involved individuals. These individuals, in turn, spend a portion of their newfound income, say 70% (MPC = 0.7), on various goods and services. This creates new income for other businesses and individuals within the economy. This cycle of spending and respending continues, with each round generating a smaller subsequent injection, ultimately leading to a greater total change in national income compared to the initial $1 billion injection. 

1.2 The Multiplier Formula

The multiplier effect is determined by the Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS) using the formula:

Multiplier=11−MPC\text{Multiplier} = \frac{1}{1 - MPC}

Or, since MPC + MPS = 1:

Multiplier=1MPS\text{Multiplier} = \frac{1}{MPS}

Where:

  • MPC (Marginal Propensity to Consume) = The proportion of additional income that is spent on consumption.

  • MPS (Marginal Propensity to Save) = The proportion of additional income that is saved rather than spent.

A higher MPC leads to a larger multiplier effect because more spending circulates through the economy.

Real-World Example: Infrastructure Investment in China

China has consistently invested in high-speed rail infrastructure. When the government spends money on rail projects, it pays construction companies, which then pay workers. These workers spend their wages, increasing demand in other sectors like housing and retail, leading to further rounds of spending.

1.3 Numerical Explanation of the Multiplier Effect

Suppose a government injects $1 billion into the economy, and the MPC = 0.8 (meaning 80% of additional income is spent, while 20% is saved).

Using the formula:

Multiplier=11−0.8=10.2=5

Total impact on national income:

1 billion×5=5 billion

Thus, an initial government spending of $1 billion results in a total GDP increase of $5 billion.

Real-World Example: 2009 U.S. Stimulus Package

Following the 2008 financial crisis, the American Recovery and Reinvestment Act (ARRA) injected $787 billion into the economy. Due to the multiplier effect, the total impact on GDP was much larger, helping the U.S. recover from recession.

1.4 multiplier value

The multiplier value, k, represents the number of times by which national output and national income rise due to an increase in autonomous expenditure. It is denoted by 1/(1-MPC) or 1/MPW where MPW = MPS+MPT+MPM. 

  • Marginal Propensity to Consume (MPC): The portion of additional income households spend on consumption. A higher MPC strengthens the multiplier effect as more income is injected back into the economy with each round.

  • MPW (Marginal Propensity to Withdraw): This term is less commonly used but represents the total proportion of additional income that households don't spend on consumption. It essentially combines the effects of the following three:

    • MPS (Marginal Propensity to Save): This refers to the proportion of additional income that households save instead of spending. A higher MPS means a larger portion is saved, potentially weakening the multiplier effect.

    • MPT (Marginal Propensity to Tax): This represents the proportion of additional income that goes towards taxes. As income rises, the amount paid in taxes might also increase, impacting disposable income available for spending.

    • MPM (Marginal Propensity to Import): This refers to the proportion of additional income that households spend on imported goods and services. Increased imports represent a leakage of income out of the domestic economy, potentially weakening the multiplier effect.

The Small Multiplier Value in Singapore is due to:

  • High savings due to the culture of thrift, compulsory savings scheme (Central Provident Fund) and the absence of a generous welfare system.

  • High imports due to the lack of factor endowments and the embracement of free trade.

Dampened and Reverse Multiplier effects

A dampened multiplier effect occurs when the economy reaches an equilibrium where AD intersects AS at the intermediate or classical range.

A reverse multiplier effect occurs when there is a withdrawal of income from the circular flow. When there is an increased withdrawal such as a rise in savings, import spending or taxation, there may be a downward multiplier effect on the rest of the economy, causing real GDP to be lower than at the start.

  • This can be used to illustrate the paradox of thrift showing how increased saving, while seemingly prudent on an individual level, can hinder economic growth in the short run.

  • Reduced Spending: When households save more, they spend less. This reduces demand for goods and services, leading to a decrease in aggregate demand (AD).

  • Lower Production and Investment: As demand falls, businesses experience a decline in sales. This can lead to production cuts, layoffs, and a decrease in overall economic activity.

  • Reduced Multiplier Effect: Lower spending weakens the multiplier effect. With less money circulating through the economy, the initial injection from savings has a smaller impact on national income.

  • However, this prediction will hold only if the economy is not at full employment and not experiencing inflation, and investment remains unchanged when savings rise.

2. Illustrating the Multiplier Effect on the Production Possibility Curve (PPC)

The Production Possibility Curve (PPC) represents the trade-offs an economy faces between different types of production. The multiplier effect influences an economy’s actual and potential growth, which can be visualized on the PPC.

2.1 Concept of Trade-Offs

The PPC is concave, reflecting the trade-off between producing different goods (e.g., capital goods vs. consumer goods). A decision to increase government spending must come at the cost of reduced spending elsewhere or increased borrowing.

Real-World Example: “Guns vs. Butter” Trade-Off

Countries must decide between spending on military defense (guns) or consumer welfare (butter). For example, during wartime, governments often shift resources toward military production, reducing civilian goods.

2.2 Actual Economic Growth (Movement Towards the PPC Boundary)

  • Actual economic growth occurs when underutilized resources (e.g., unemployed labor) are used more efficiently, moving the economy closer to its PPC boundary.

  • The multiplier effect can help achieve this by reducing unemployment and increasing output.

Real-World Example: India’s IT Boom

In the 2000s, government investment in IT and software parks led to higher employment in the tech sector, increasing output and shifting the economy closer to its full potential.

2.3 Potential Growth (Outward Shift of the PPC)

  • Potential growth occurs when an economy’s productive capacity increases, shifting the PPC outward.

  • This can happen through technological advancements, education, and infrastructure development.

Real-World Example: Singapore’s Smart Nation Initiative

Singapore’s investment in AI, digital infrastructure, and automation is expected to increase its long-term productivity, shifting the PPC outward and enabling higher future growth.

2.4 Underemployment and Underutilization of Resources

  • If resources (e.g., labor or capital) are not fully utilized, the economy operates inside the PPC.

  • This happens during recessions, when high unemployment leads to lost economic potential.

Real-World Example: Eurozone Crisis (2010-2015)

Countries like Greece and Spain experienced high unemployment and low output following the Eurozone debt crisis, keeping their economies inside their PPC.

3. Discussion Questions

  1. Why does a higher MPC result in a larger multiplier effect?

  2. How can government spending lead to actual vs. potential economic growth?

  3. What are the limitations of using the PPC to illustrate macroeconomic concepts?

  4. Can the multiplier effect always stimulate economic growth, or are there risks?

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