13 Aug The Multiplier and links to Keynesian Economics

The Multiplier and links to Keynesian Economics

• The concept of the multiplier process became important in the 1930s when John Maynard Keynes suggested it as a tool to help governments to maintain high levels of employment
• This “demand-management approach”, designed to help overcome a shortage of capital investment, measured the amount of government spending needed to reach a level of national income that would prevent unemployment.

What determines the value of the multiplier?

The value of the multiplier depends on:

• Propensity to import
• Propensity to save
• Propensity to tax
• Amount of spare capacity
• Avoiding crowding out

Key points

• 1.The higher is the propensity to consumedomestically produced goods and services, the greater is the multiplier effect. The government can influence the size of the multiplier through changes in direct taxes. For example, a cut in the rate of income tax will increase the amount of extra income that can be spent on further goods and services
• 2.Another factor affecting the size of the multiplier effect is the propensity to purchase imports. If, out of extra income, people spend their money on imports, this demand is not passed on in the form of fresh spending on domestically produced output. It leaks away from the circular flow of income and spending, reducing the size of the multiplier.
• 3.The multiplier process also requires that there is sufficient spare capacity for extra output to be produced. If short-run aggregate supply is inelastic, the full multiplier effect is unlikely to occur, because increases in AD will lead to higher prices rather than a full increase in real national output. In contrast, when SRAS is perfectly elastic a rise in aggregate demand causes a large increase in national output.
• 4.Crowding out – this is where (for example) increased government spending or lower taxes can lead to a rise in government borrowing and/or inflation which causes interest rates to rise and has the effect of slowing down economic activity.

When will the multiplier effect be large?

In short – the multiplier effect will be largerwhen

1. The propensity to spend extra income on domestic goods and services is high
2. The marginal rate of tax on extra income is low
3. The propensity to spend extra income rather than save is high
4. Consumer confidence is high (this affects willingness to spend gains in income)
5. Businesses in the economy have the capacity to expand production to meet increases in demand

Evaluation: Time lags and the multiplier effect

• It is important to remember that the multiplier effect will take time to come into full effect
• A good example is the fiscal stimulus introduced into the US economy by the Obama government. They have set aside many billions of dollars of extra spending on infrastructure spending but these capital projects can take years to be completed. Delays in sourcing raw materials, components and finding sufficient skilled labour can limit the initial impact of the spending projects.