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  1. With reference to the concept of the multiplier explain how the level of national income might be affected by a new governmentt spending project worth $100 million. (10 marks)

An initial change in AD can have a greater final impact on equilibrium national income. This is known as the multiplier effect and it comes about because injections of demand into the circular flow of income stimulate further rounds of spending.

If there is an increase in investment of any amount of money, the final increase in national income will increase by more than this value, known as the MULITPLIER EFFECT.An example of this effect would be if a company invested £100m in new factories.  The money would be spent on contractors, who would partly use it to pay their workers, who in turn would spend it on anything from food to appliances.  If, for example £10m of the total £100m were spent on food, then the food manufacturers would spend this on a variety of products, further increasing the national income.  Keynes argued that the multiplier effect would create new jobs within the economy as the spending that caused the creation of one job would indirectly cause the creation of many more.  This can be shown using the circular flow of income model.  If households spend 9/10 of their gross income, then the remaining 1/10 will either be saved or paid to the Government as tax.

For instance in stage 1 we can consider  £100m flowing into firms, which is distributed out as wages and profits to the households.  The households spend the money back on firms and the cycle continues, but each time there are withdrawals of 0.1 lost through savings and taxes.  So during the second stage only £90m goes back to the firms and on the third stage £81m, etc.  The process continues with gradually smaller amounts being added to the national income, until the £100m of investment has led to a final increase in national income of £1000m.  In this case the value of the MULTIPLIER is 10.0.  The multiplier model states that the higher the leakages the smaller the increase in income that continues to flow around the economy at each stage following an increase in spending. Therefore, the higher the leakages the smaller the value of the multiplier.

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Extra investment is only one cause for the multiplier effect on aggregate demand.  Any increase of theinjections into the circular flow will lead to a multiple increase in income in the economy.  So, an increase in Government spending would lead to a multiple increase in income, as would an increase in export spending.

Let’s take an example of an investment in Location A, The investment at Location A would cause a multiplier effect on income because when money is invested it circulates through the economy many times, adding to the national income.  For example, the £468 million spent on the plant (plus the extra ...

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