the-multiplier-and-basic-accelerator-process

The Influence of AD on the Level of Economic Activity

• Aggregate demand (AD) is a major determinant of overall level of output (GDP) and employment in the economy

Diagram: The Influence of AD on Real GDP

Diagram analysis

• When an injection occurs in the economy, such as through increased government spending or investment, the AD curve will shift to the right (AD₁ to AD₂)

  • This increases the overall level of real output 

  • When real output increases, firms typically need to hire additional workers to meet the higher demand for goods/services 

  • The increased employment is linked to an increase in economic growth 

• When a withdrawal occurs in the economy, such as through more taxes or spending on imports, the AD curve will shift to the left (AD₁ to AD₃)

  • This decreases the overall level of real output 

  • When real output decreases, firms typically reduce their workforce to align with reduced demand for goods/services 

  • The decreased employment is linked to a decrease in economic growth 

The Multiplier

• The multiplier states that any injection in the economy leads to a greater impact on the economy than the value of the initial injection

  • E.g. If the Brazilian government injected an additional 5bn Brazilian real (BZL) into the economy through government spending, it may lead to an increase in real income of 15bn BZL

    • In this example, the value of the multiplier would be 3

• The multiplier process is based on the idea that one individual’s spending is another individual’s income

  • An increase in consumption immediately increases AD

    • Store owners who have benefited from the extra consumption now have extra income

    • They spend some of that income on goods and services

    • Their expenditure on goods and services is now income for the next tier of individuals 

• Due to the successive rounds of spending, the final increase in national income is much larger than the initial injection
   

• The size of the multiplier is influenced by the size of leakages that occur during the process

  • The higher the leakages, the smaller the marginal propensity to consume (MPC)

  • The higher the marginal propensity to consume, the lower the leakages and the greater the multiplier will be 

• The marginal propensity to consume (MPC) is the proportion of additional income that is spent on consumption (C) 

Diagram: The Effect of the Multiplier

Diagram analysis

• The initial injection shifts AD to the right, from AD₁ to AD₃

• The result of the multiplier process is that there is then a secondary movement of AD to the right, from AD3 to AD2

  • If the multiplier were 2, this would double the initial movement

• The multiplier can also work in reverse when injections are reduced (downward multiplier effect)

Calculating MPC & The Multiplier

• Marginal Propensity to Consume (MPC) is the proportion of additional income that is spent on consumption (C)

  • It can be viewed as how many pence is spent by households on consumption from every additional £1 of income

  • It can be calculated using the formula

• The value of the multiplier can be calculated by using the formula

• The greater the MPC, the higher the value of the multiplier, and vice versa

• Any change in one of the factors that impacts on disposable income will change the multiplier

  • If taxes increase, the value of the multiplier reduces

  • If interest rates increase, savings increase, consumption decreases and the multiplier reduces

  • If exchange rates appreciate, the level of imports will increase and the multiplier decreases

  • If confidence in the economy increases consumption increases and the multiplier increases 

• It is extremely useful for the Government to know the value of the multiplier

  • They can use it to judge the likely economic growth caused by increased spending

  • The bigger the MPC, the greater the multiplier effect will be 

• There is a time lag as it takes time for the successive rounds of income to work through the economy