Use the multiplier to explain how an increase in any component of aggregate demand will increase GDP. What are the practical problems in trying to determine the exact size of a multiplier effect?
Use the multiplier to explain how an increase in any component of aggregate demand will increase GDP. What are the practical problems in trying to determine the exact size of a multiplier effect? Under what circumstances will a positive multiplier effect not be advantageous for an economy?
Any time new spending is introduced into or removed from an economy, it will cause GDP to change by some multiple of the spending shock. This takes place through the multiplier process in aggregate spending largely through changes in consumption expenditure. Therefore the principle of the multiplier is that a change in the level of injections of leakages brings about a relatively greater change in the level of national income. The level of change depends greatly on consumers' marginal propensity to consume (MPC)- how much additional income will they spend or save-, the larger the MPC is, the larger the multiplier effect and so the biggest change to GDP.
As economic activity starts to increase economic agents may become more optimistic about economic prospects and thence firms increase investment and consumers spends more. Therefore the pace of recovery is magnified. Equally small initial downturns in the economy may be greatly increased as negative expectations are often self-fulfilling and create decreased aggregate spending and reduced economic activity. Even in the absence of such expectations effects, the process of income determination on the circular flow will tend to magnify initial changes in aggregate demand. This is because initial changes in consumer spending, injections and leakages affect subsequent rounds of spending in the circular flow. Therefore there is a build up of secondary effects which ass to the initial effect. For example, an increase in government spending on domestically produced weapons will cause an initial rise in output and incomes from weapon production. Then now richer and newly employed workers will reduce their own spending on consumer goods. Therefore the local areas surrounding the weapon factories, shops, cinemas and leisure facilities will be faced with increased demand and will perhaps employ more workers or up their salaries. This further increases demand and so on. Therefore the initial effect of aggregate demand is multiplied by an increase in the income of consumers and demand for consumer goods.
The operation of the multiplier effect can be shown using an example, but assuming that investment and savings are the only injections and leakages respectively. If a firm decides to construct a new building costing £1000, then the income of the builders and suppliers of the raw materials will increase by £1000. However, the process continues, if it is assumed that the recipients of the £1000 have an MPC of 2/3, they will spend £666 and save the rest. This spending creates extra income for another group of people. If it is assumed that they also have an ...
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The operation of the multiplier effect can be shown using an example, but assuming that investment and savings are the only injections and leakages respectively. If a firm decides to construct a new building costing £1000, then the income of the builders and suppliers of the raw materials will increase by £1000. However, the process continues, if it is assumed that the recipients of the £1000 have an MPC of 2/3, they will spend £666 and save the rest. This spending creates extra income for another group of people. If it is assumed that they also have an MPC of 2/3, they will spend £444 and save the rest. This process will continue with each new round of spending being 2/3 of the previous round. Therefore a long chain of additional income, spending and saving is established. The process will come to a halt when the additions to savings are £1000. This is because the change in savings is now equal to the original investment and therefore the economy is returned to equilibrium. At this point the additions to income total £3000, therefore £1000 extra investment caused a £3000 increase in income; GDP rises substantially because the value of the multiplier is 3.
However, there are many problems associated with calculating the exact size of the multiplier effect. Principally, there are many unrealistic assumptions made in the calculation, as government intervention as a prime example, is not taken into consideration, taxation and government expenditure on health, education or transport is not accounted for. These could have huge effects on the multiplier's value, for example, if a company pays its workers higher wages, this would lead to higher demand from these consumers, however, it would not be a high as predicted because workers would be paying income tax and with additional wages they may be moved into higher tax brackets so a larger percentage of this extra income would be claimed by the government than on their previous earnings due to the progressive nature of taxation. Workers may also contribute a portion of their income to a pension plan.
It is also incredibly difficult to calculate a consumer's MPC because consumers do not always have the same tastes and something as trivial as the season may change a consumer's MPC, so even if a successful result is achieved it is likely to change and be inaccurate very quickly. In addition, collecting this information may be very hard as survey's will have to be carried out and this is often unreliable, it could be done by looking at an individual's additional income and the amount they spend, however, this is also impractical because it is such a small scale and there is a great diversity between consumers' habits in an economy. Economists, such as Michael Kalecki, have found differences between the MPC of those who earned wages or salaries and those who live off unearned income. He showed that these differences in MPC mean that income distribution can greatly affect the value of the multipliers and therefore the national income equilibrium. If a successful calculation cannot be found for the multiplier then an accurate determination of the effect cannot be scaled.
In addition, inflation may make it difficult to identify the multiplier in a real economy. Increases in expenditure may be absorbed by price increases rather than increases in output. Thus output will not increase by as much as aggregate demand. Price increases may also affect people's real wealth and therefore change their level of consumption. Different types of investment will have different multiplier effects. For example, extra spending on defence will have a different effect from spending on house building because of the different MPCs of recipients and the differences from whether parts and materials are imported or from domestic producers. The bulky nature of building materials means that most will come from domestic producers and therefore the multiplier effect is likely to be larger than for spending on manufactured goods where many of the components are likely to be imported.
Investment may also increase with spending and the multiplier functions on the assumption that all investment is autonomous, however, as private companies receive more capital they are likely to invest again in the economy. This endogenous investment would magnify the multiplier effect as injections could then increase with income. Time lags are also a problem because the various rounds of spending, which cause the multiplier effect, take time to build up; therefore the strength of the effect may not be seen for some time. This can cause difficulties in trying to examine the exact size of the multiplier effect because it is hard to predict the outcome and in the future it is hard to calculate looking back because so much activity will have occurred. The multiplier does not suit real life economics because it also is based on the assumption that there is not technological advance, however, this is always the case in a growing economy and significantly alters the relationship between inputs and outputs.
A positive multiplier effect may not always be advantageous for an economy. The multiplier induces higher output as aggregate demand grows which causes the economy to grow. If this growth is too quick due to a large number of transactions and a sudden rise in consumer spending this could cause demand led inflation. This may also be the case if the economy is at full capacity and there is no potential growth, an increase in aggregate demand will cause only an increase in the price level because resources are fully employed. Inflation causes businesses to lose confidence because they cannot predict price fluctuations in the near future and planned investment will fall causing an economic downturn and no more capacity will be created in the economy as capital does not rise so inflation will spiral even higher. Savers also experience a negative impact as the real value of their savings is reduced.
Even if the economy is not quite at full capacity and there is some unemployment, this could still have negative effects. This is because many workers may be structurally unemployed and unless they are trained in the growing sector which the multiplier is operating this could still have an inflationary effect because the structure of the economy is such that even though there is spare capacity there is no flexibility of labour, this could be applied to any of the factors of production.
The multiplier may also not cause growth for an economy as increased consumer spending may lead to more goods and services being imported from outside the domestic economy, in this situation the marginal propensity to import rises and the positive multiplier effect will not be totally realised because expected increases in aggregate demand will not materialise. In addition, regional differences in the economy can also mean that a positive multiplier effect does not lead to the economy benefiting because a rise in incomes in one area may result in consumption from another, therefore regional divides will become only more pronounced.
In conclusion, an initial change in AD can have a greater final impact on equilibrium national income in the operation of the multiplier effect. There are problems in calculating the multiplier effect mainly to do with the ceteris paribus in that the key assumptions of the simple multiplier are not applicable to the real world economy. Finally, in the situation where the economy is at full capacity this is the main state in which the multiplier operating positively will have negative implications for the economy.
Ali Llewellyn K
