Contents
Defining the multiplier and how the multiplier works
The multiplier is when an initial increase in an injection leads to an even larger increase in real GDP.
Injections could include investment, government spending or net exports.
How does the multiplier process work?
- Suppose there is an initial injection, such as a rise in government spending.
- A rise in government spending (G) increases aggregate demand (AD). This is because G is a component of AD.
- In other words, total demand increases for goods and services produced by firms. This increases real GDP in equilibrium too.
- The firms, which are now selling more to the government, increase their revenue and hence profits.
- Firms may use those profits to increase workers’ wages.
- This increases workers’ disposable income. So workers spend more, increasing consumption.
- So aggregate demand (AD) rises further. This leads to real GDP rising in equilibrium.
- This cycle continues.
- Workers consume more of firms’ goods, so firms make more profits. So firms pay workers more, so workers consume more etc.
In short, the injection (an increase in investment / government spending / net exports) leads to an increase in consumption.
So AD increases by more than the initial injection.
The negative multiplier effect
Note the multiplier also works in reverse. This is sometimes called the negative multiplier effect.
Suppose an injection decreases. Then this reduces firms’ profits, so firms cut workers’ wages. This leads to lower consumption.
In other words, AD falls by more than the initial fall in the injection. As a result, real GDP may also fall more than the initial fall in the injection.
What is the multiplier ratio?
The multiplier ratio is the ratio of the increase in real GDP to the increase in the initial injection.
For example, suppose exports increase by £10 million. Suppose also that real GDP increases by £20 million due to the initial increase in exports.
Then the multiplier (ratio) is 20/10 = 2.
What determines the multiplier? The role of marginal propensities
The MPC and the multiplier
The marginal propensity to consume (MPC) is the proportion of an extra pound of income that is spent on consumption.
- For example, suppose that, after earning £1 more, consumers spend an extra 40p. In this case, the MPC is 0.4.
The multiplier depends on the MPC. Specifically, the multiplier is:
A rise in the MPC increases the multiplier.
- A higher MPC means a greater proportion of workers’ extra incomes are spent, instead of being withdrawn from the circular flow. This increases the multiplier.
- This can also be seen from the multiplier formula. A higher MPC reduces the denominator of the multiplier. So, the multiplier increases overall.
The MPW and the multiplier
The marginal propensity to withdraw (MPW) represents the proportion of an extra pound of income that is withdrawn / leaks from the circular flow of income.
We assume that the extra £1 earner must be split between consumption and withdrawals. In other words the MPC and MPW must sum to 1.
The MPW is made up of three components. Each component reflects one of the three withdrawals from the circular flow of income :
- MPS, the marginal propensity to save.
- MPT, the marginal propensity for tax.
- MPI, the marginal propensity to import.
- Together the three components sum up to make the MPW.
- MPW = MPS + MPT + MPI
Given the MPC and MPW sum to 1, we can rewrite the formula for the size of the multiplier in terms of MPW:
Or equivalently:
A rise in the MPW leads to a fall in the size of the multiplier.
- A rise in the MPW corresponds to a fall in the MPC.
- This is because the MPC and the MPW sum to 1.
- In other words, when workers’ incomes rise by £1, as MPW rises, a greater proportion of that £1 is withdrawn (or leaks) from the economy. Meanwhile, a smaller proportion of that extra income is consumed.
- This reduces the extent of the multiplier.
How the multiplier influences shifts in aggregate demand
Suppose there’s an increase in an injection into the economy. For example an increase in government spending.
This shifts aggregate demand (AD) to the right from AD to AD1. This is because government spending is a component of AD.
The multiplier causes a further shift in AD from AD1 to AD2.
This is because the initial increase in government spending leads to more demand for firms’ goods and services. So firms earn higher revenues and profits.
So firms pay their workers more, so workers consume more and so on.
Suppose instead there is a fall in an injection. This would initially cause AD to shift left.
Following this, the negative multiplier effect would lead to a second shift left in AD – the opposite of the diagram above.
Practice question on the multiplier
Here is a short question on the multiplier. It is a 5 mark question, split into three parts.
Suppose the marginal propensity to save is 0.2, the marginal propensity for tax is 0.25 and the marginal propensity to import is 0.25.
(a) Calculate the increase in real GDP that results from an increase in government spending by £3 million. (2 marks)
(b) Suppose the government is aiming for real GDP to increase by £70 million. How much would government spending have to increase initially, in order for real GDP to increase by £70 million overall? Refer to the multiplier in your calculations. (2 marks)
(c) Which one of the following options, when increased, is most likely to increase the multiplier ratio? (1 mark)
A The marginal propensity to import.
B Real GDP.
C The marginal propensity to consume.
D Exports.
Related Edexcel A Economics A Level resources
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