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. 

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. 

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. 





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