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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?

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Introduction

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. ...read more.

Middle

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. ...read more.

Conclusion

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 1 ...read more.

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