Macroeconomics

Table of Contents

1. Topic pack - Macroeconomics - introduction
2. 2.1 The level of overall economic activity (notes)
3. 2.1 The level of overall economic activity (questions)
4. Section 2.2 Aggregate demand and supply (notes)
   1. Aggregate demand and supply - introduction
   2. The AD/AS model
   3. Aggregate demand curve
   4. Changes in aggregate demand
   5. Short-run aggregate supply (SRAS)
   6. Changes in SRAS
   7. Long run aggregate supply (LRAS) - classical
   8. Changes in LRAS - classical
   9. Long run aggregate supply (LRAS) - Keynesian
   10. Aggregate supply changes
   11. Full employment level of national income
   12. Equilibrium national income
   13. The essentials of AD and AS
   14. Changes in short-run equilibrium - summary
   15. Equilibrium in the long run?
   16. Equilibrium in the Keynesian model
   17. Inflationary and deflationary gaps
   18. Keynes vs. Hayek (video)
   19. The Keynesian multiplier
5. Section 2.2 Aggregate demand and supply (simulations and activities)
6. 2.2 Aggregate Demand and Aggregate Supply (questions)
7. 2.3 Macroeconomic objectives (notes)
8. Low Unemployment
9. 2.3 Macroeconomic objectives (questions)
10. 2.4 Fiscal policy (notes)
11. 2.4 Fiscal policy (questions)
12. 2.5 Monetary policy (notes)
13. 2.5 Monetary Policy (questions)
14. Section 2.6 Supply-side policies (notes)
15. 2.6 Supply-side policies (questions)
16. Print View

The Keynesian multiplier (Higher Level Only)

Syllabus: Explain, with reference to the concepts of leakages (withdrawals) and injections, the nature and importance of the Keynesian multiplier.

You need to be aware that changes in any Expenditure component (C,I,G,X,M) will have a larger effect on GDP than just the value of the initial change. This is known as the multiplier effect.

Notice that changes in C are a little more complicated as it is not (strictly) a recognised injection into the Circular Flow. However, autonomous (or non-induced) changes in consumption have the same effect as a decrease in saving and therefore act as an injection: Decreasing withdrawals has the same effect as increasing injections.

If there was an injection of extra spending (and therefore income as one person´s spending MUST be another person´s income, remember) into government-provided health care in an economy some of the money will go to doctors and nurses in the form of a salary increase or to employ new doctors and nurses: New building and equipment will could also be bought and this will boost sales revenue (income) of those making such items. This 'first round effect' is the initial increase in income brought about through the increased spending within the economy.

However, doctors and nurses eat, drink and consume stuff just like the rest of us, and they will choose to spend some of their additional salary and save the rest. Do you recognise these concepts? Refer to Page 19 and marginal propensity to consume (MPC) and marginal propensity to save (MPS).

The MPC is defined as the proportion of extra income received that is used for spending.

The MPS is defined as the proportion of extra income received that is used for saving.

NB. MPC+MPS must equal 1 since income can only be spent or saved.

So, if a doctor was awarded an extra $100 in salary and chose to spend $80 of this, his or her MPC would be 0.8 and his or her MPS would be 0.2.

The producers (sellers) of the goods and services that the doctors and nurses and equipment producers now buy may take on more labour to cope with the extra demand and these new employees will also spend part of their additional income and so it goes on.

The amount that is passed on will diminish (because of withdrawls  reducing the extra spending) in each successive round of spending but the overall effect on the economy will be greater than the initial injection.

The Importance of the Multiplier

If Governments decide to use keynesian demand management policies they must take into account both the size of the multiplier and the time lag it involves while the multiplier process works its way through the economy. Too much initial injection will lead to inflation but too little will not remove unemployment.

Barrack Obama`s famous stimulus policy (begun 2008) to reduce unemployment was criticised for some years as not working, yet the effects were beginning to be seen in (2014) and unemployment has decrease significantly in 2015.

Calculating the Multiplier

Syllabus: Calculate the multiplier using either of the following
formulae.
                                1       
                            (1− MPC )

OR

                                1            
                    (MPS + MPT + MPM)

Another way to remember this is it is 1 over the withdrawals. Also note that 1-MPC is exactly the same as the withdrawals since they both sum to 1.

The size of the multiplier can be worked out by dividing the increase in national income (Y) that eventually occurs by the increase in injections that caused it.

So, for example, if an increase in government spending of $10m caused GDP to rise by $50m, this would be a multiplier of 5 (There are no units it is a multiplier). This would be found by dividing $50m (the change in GDP) by $5m (the initial change in injection of expenditure).

The key determinants of the value of the multiplier are:

• The size of the savings ratio - the more people save of any increase in income (MPS), the less the increase in spending at each stage of the process, the smaller the multiplier.
  
• The amount spent on imports - if a lot of the extra spending created goes on imported goods and services, then this money will be lost out of the country and not passed on within the economy (the marginal propensity to import or MPM).
• The level of taxation - any increase in income will also mean higher tax revenue. However, if the government use this extra revenue to spend on public sector investment and employment, then this may help the process continue.

Overall, the value of the multiplier therefore depends on the amount of any increase in income that is spent by the people receiving it. The higher the MPC, the higher the value of the multiplier will be.

Syllabus: Use the multiplier to calculate the effect on GDP of a change in an injection in investment, government spending or exports (I,G,X)

Syllabus: Draw a Keynesian AD/AS diagram to show the impact of the multiplier.

Figure 1 Diagram to show Multiplier effect

Figure 1 AD shifts due to the initial injection and then has a greater shift due to multiplier effect - I don´t know why it says narional income but I think we can assume it means national income. Anyway, the point is to show 2 shifts with the second shift of the greater magnitude.

But, how exactly is the multiplier determined? (For the more mathematically inclined)

Past Paper Essay

Nov 2011

2. (a) Explain what the multiplier is and, using a numerical example, demonstrate how it can be calculated. [10 marks]

    (b) Evaluate whether real Gross Domestic Product (GDP) can be increased by the use of demand-side policies.
    [15 marks]