The Multiplier Effect

IB EconomicsMs. Villarreal

The Multiplier Effect

The multiplier effect tells us when one of the components of AD is changed, the final impact on AD will be greater than the initial impact on that component.

In other words, any increase in aggregate demand will result in a proportionately larger increase in national income.

Circular flow model

Government spending and

business investment are

injections into the circular

flow of income and any

injections are multiplied

through the economy as

people receive a share of the

income and then spend a part

of what they receive.

Government spends $100 million on a

school building project

The people who receive the income from the school building project repay some of it back to the government in the form of taxes, some of it is saved, some of it is spent on foreign goods and services, and the rest is spent on domestically produced goods and services.

Government spends $100 million on a

school building project

Rounds of spending

The money that is spent goes as income to a new set of recipients, who then behave in the same way– they pay some as taxes, some is saved, some is spent in imports, and the rest is spend on domestic goods and services.

During each “round”, some income is withdrawn from the circular flow and some stays to be re-spent.

The Multiplier Effect

When the government utilizes fiscal policy to stimulate aggregate demand, the “target” change can be very difficult to calculate, due to the multiplier effect. • If the multiplier effect stimulates AD above the

target, the economy will suffer inflation. • If the multiplier effect is lower than estimated

and AD fails to reach the full employment level of output, then unemployment will persist.

Assessment

In at least two paragraphs, describe the multiplier effect and its impact on fiscal policy.

Tomorrow’s lesson: calculating the multiplier effect

How to measure the multiplier effect

Remember the multiplier effect tells us when one of the components of AD is changed, the final impact on AD will be greater than the initial impact on that component.

We now need to calculate by how much the final impact be greater than the initial impact.

Measuring the Multiplier Effect

In order to measure the multiplier effect, we must know certain things about an economy, such as consumers tendencies to consume, save, buy imports, and the marginal tax rate of the economy.

We use this information to calculate the multiplier.

Calculating the multiplier

We can use the equation:

K= 1/1-mpc where mpc is the marginal propensity to consume, or consumers tendency to spend income on goods and services.

Find the multiplier

Calculate the multiplier for an economy where the marginal propensity to consume is 0.75

K= 1/1-0.75

K= 4

Find the multiplier

By how much will national income increase in total if there is an investment of 50,000?

4 x $50,000= $200,000

An investment of $50,000 will result in an final increase in national income of $200,000

Assessment

Complete student activity 16.3;

For homework, answer examination question HL on page 202