AS Macro Revision: Multiplier, Accelerator and Keynesian Economics

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Information about AS Macro Revision: Multiplier, Accelerator and Keynesian Economics

Published on February 21, 2014

Author: tutor2u



AS Macro Revision Multiplier, Accelerator Effects and Keynesian Economics Spring 2014

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The Multiplier Effect A change in one of the components of aggregate demand (AD) can lead to a multiplied final change in the equilibrium level of GDP 1. The multiplier effect comes about because injections of new demand for goods and services into the circular flow of income stimulate further rounds of spending – in other words “one person’s spending is another’s income” 2. This leads to a bigger final effect on national output and total employment The formal calculation for the value of the multiplier is: Multiplier = 1 / (sum of the propensity to save + tax + import)

An Example of the Multiplier Effect The government injects £200m in a project to build thousands of new affordable houses Why is the final increase in measured GDP likely to be more than £200m? If the final rise in GDP is £300m the value of the multiplier = 1.5 If the final rise in GDP is £250m the value of the multiplier = 1.25

The Multiplier Effect Process If asked to do so, explain the process that lies behind the multiplier effect – focusing on the extra demand and incomes created A new-build housing project injects £200m of new demand and output into the economy Many businesses benefit directly including building supply industries, architects etc The government injects £200m in a project to build thousands of affordable new houses Building new houses generates a new flow of factor incomes – including wages and profits Will the extra income stay inside the circular flow of income and spending? If so, the multiplier effect is likely to be strong

Marginal Rate of Leakage and the Multiplier Value The rate of leakage from the circular flow Assume that for each £100 of extra income • 10% is saved • 20% is taken in taxation • 20% leaks from the economy in imports Multiplier = 1 / (sum of the propensity to save + tax + import) If propensity to save = 0.1 Propensity to tax = 0.2 Propensity to import = 0.2 Then the multiplier = 1/0.5 = 2 At each stage the extra money flowing around the circular flow gets smaller • £20m saved • £40m taxed • £40m imports £200m Injection £100m extra GDP • £10m saved • £20m taxed • £20 imports • £10m saved • £20m taxed • £20m imports £50m extra GDP

Elasticity of Aggregate Supply & the Multiplier Effect When AS is highly elastic, multiplier effect likely to be high When AS in inelastic, hard for AS to expand to meet rising AD GPL GPL AS GPL1 AS GPL1 AD2 AD1 Y1 Y2 AD2 Y AD1 Y1 Y1 Y

Summary of Factors Affecting Value of the Multiplier High Multiplier Value Economy has plenty of spare capacity Low Multiplier Value Economy is close to it’s capacity limits Propensity to import and tax is low Rising demand causes rising inflation High propensity to consume any extra income Higher inflation causes rising interest rates The Size of the Fiscal Multiplier Government investment—things like infrastructure building— results in higher multipliers. Economists at the IMF have calculated the longrun multiplier value at 1.5 for developed countries and 1.6 for developing countries. Source: The Economist

We add new resources / links / articles every day to our Economics blogs Follow this link for the AS Macro Blog on Tutor2u

The Accelerator Effect Where planned capital investment is linked positively to the past and expected growth of consumer demand or national income • Consider an industry where demand is rising quickly • Firms will respond by making using their existing productive capacity or running down stocks of finished products • If they expect high demand will be sustained – they will increase spending on plant and machinery, factories and new technology in order to increase their supply capacity • This causes an accelerator effect – where a given change in demand for consumer goods and services will cause a greater percentage change in demand for capital goods

Examples of the Accelerator Effect in action The Negative Accelerator Effect Investment to create extra capacity in cloud storage Investment in 4G mobile networks Expanding fleet sizes of growing airlines Capital investment in renewable energy When the rate of growth of demand in an industry slows then net investment spending by businesses often falls. E.g. Declining investment in steel plants in a recession or a drop in investment demand when subsidies for renewables are cut

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Key Keynesian Ideas An understanding of Keynesian ideas can be helpful in evaluating macroeconomic stability in terms of prices, jobs and incomes • Keynesians believe that free markets are volatile and not self correcting • The free-market system is prone to periods of recession & depression • The volatility of aggregate demand (AD = C+I+G+X-M) can be explained by changes in consumer and business sentiment – known as animal spirits • In a world of stagnation or depression direct intervention in the economy may be essential John Maynard Keynes was born in 1883. He was educated at Eton College and at Cambridge University - where he later taught. He died in 1946

The Importance of Animal Spirits John Maynard Keynes coined the notion of animal spirits which refers to the driving force that gets people going in the economy • Animal spirits refers to a mix of confidence, trust, mood and expectations and animal spirits can fluctuate very quickly as populations of people change their thinking • When animal spirits are poor, individuals save more, businesses save more too and, because demand and profits are lower than expected, they cut back on production and perhaps postpone or cancel capital investment projects. • Higher saving and reduced investment both have the effect of reducing demand and incomes in the circular flow causing an economic contraction – this is called the “paradox of thrift”!

The Keynesian Liquidity Trap A liquidity trap occurs when low interest rates and a high amount of cash balances in the economy fail to stimulate aggregate demand • In normal circumstances it is possible to boost demand by cutting interest rates. But there is a zero floor for nominal interest rates • Even if interest rates can be lowered this may have little effect if people cannot or will not borrow. This is known as the liquidity trap. • At this point, AD can only be boosted by the Government borrowing more, either to spend directly or to give to others via tax cuts • Keynesians believe that size of the fiscal multiplier effect is higher for government spending than it is for tax cuts • When private sector demand for goods and services is low, the government needs to find a compensating source of demand to rebalance the economy – and the solution comes from the government in the form of higher borrowing or less saving

Keynesian Approaches to Managing Demand Keynesian economists tend to favour the active use of fiscal policy as the may way of managing demand and economic activity Active measures needed to inject extra demand can drag the economy out of a recession Keynesians favour labour-intensive projects e.g. Transport infrastructure and new housing Counter cyclical policies Government capital spending Targeted tax changes Tax cuts for lower income groups with higher propensity to spend boosts AD Government borrowing can pay for itself Depending on the size of the fiscal multiplier – borrowing will create more tax revenues

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