Keynesian Multiplier Process

Keynesian Multiplier Process

1. The Keynesian multiplier process WACE Economics – Unit 4 Video 10.2

2. (c) Andrew Tibbitt 2017 The impact of an autonomous change in spending in the economy is bigge r than the expenditure change that caused it. In other words the impact of the spending change is multiplied . The autonomous spending change sets off a domino or ripple effect around the economy called the multiplier process . Context Slide 2

3. (c) Andrew Tibbitt 2017 T he multiplier process happens because: 1) One person’s spending is another person’s income 2) Extra income forms the basis for further spending Autonomous Spending Income Induced Spending Income Induced Spending Income Induced Spending Slide 3 The multiplier process

4. (c) Andrew Tibbitt 2017 Any autonomous change in spending can set off a multiplier process : Consumption Government spending Exports Investment Savings Taxation Imports Change in injections Change in Leakages Slide 4 Any change in spending sets it off

5. (c) Andrew Tibbitt 2017 The multiplier is a number that relates the final change in real GDP to the autonomous expenditure change that brought it about . K = final change in real GDP autonomous change in expenditure Hence Change in income = spending change x multiplier (k) By definition it will (almost always) be more than 1 (unless there is a change in the price level) Slide 5 The multiplier coefficient (k)

6. Strength of multiplier depends on the proportion of extra income that is spent within the economy, that is on the value of the marginal propensity to consume . Multiplier k = 1 / (1 – MPC) or k = 1 / MPS Note: MPC + MPS = 1 (c) Andrew Tibbitt 2017 Slide 6 Strength of the multiplier (k)

7. (c) Andrew Tibbitt 2017 income E xpenditure 45 o Ex = Y AEx1 AEx2 Equilibrium starts at 175 Autonomous spending increase of 50 AEx1 shifts to AEx2 Equilibrium income = 275 Multiplier i s 2 100 150 175 275 275 175 The rise in income ( 100) is x2 the size of the spending change that brought it about (50) . Slide 7 Showing the multiplier’s strength

8. (c) Andrew Tibbitt 2017 Income Expenditure 45 o Ex = Y AEx1 AEx2 Autonomous (new) spending change 64m directly creates extra income 64m 32m 32m 16m 16m which induces more spending which creates extra income which induces more spending which creates extra income MPC = 0.5 Spending change = 64 128m Slide 8 Step by step multiplier process

9. (c) Andrew Tibbitt 2017 Income Expenditure 45 o Ex = Y AEx1 AEx2 Spending cut 64m directly reduces income 64m 32m 32m 16m 16m which reduces spending which reduces income which reduces spending which reduces income 128m Slide 9 It works in reverse too

10. (c) Andrew Tibbitt 2017 A t each stage some dollars leak out of the circular flow so what is passed on gets less and less Y = $64m Induced Ex = $48m Y = $48m Y = $36m Ex =$64m Leakage 0.25 x 64 = 16 Leakage 0.25 x 48 = 12 Induced Ex = $36m Induced Ex = $27m Leakage 0.25 x 36 = 9 Slide 10 Why doesn’t process go on and on?

11. (c) Andrew Tibbitt 2017 What is critical is the proportion of extra income that is passed on (and not passed on) at each stage. Y = $64m Induced Ex = $48m Y = $48m Y = $36m Ex =$64m Leakage 0.25 x 64 = 16 Leakage 0.25 x 48 = 12 Induced Ex = $36m Induced Ex = $27m Leakage 0.25 x 36 = 9 75% passed on 25% leaks out Slide 11 The importance of MPC and MPS

12. (c) Andrew Tibbitt 2017 What is critical is the proportion of extra income that is passed on (and not passed on) at each stage. Y = $64m Induced Ex = $32m Y = $32m Y = $16m Ex =$64m Leakage 0.5 x 64 = 32 Leakage 0.5 x 32 = 16 Induced Ex = $16m Induced Ex = $8m Leakage 0.5 x 16 = 8 50% passed on 50% leaks out Slide 12 The importance of MPC and MPS

13. (c) Andrew Tibbitt 2017 What is passed on is called the marginal propensity to consume. What is not passed on is the marginal propensity for leakages (paying tax, buying imports, savings) Y = $64m Induced Ex = $32m Y = $32m Y = $16m Ex =$64m Leakage 0.5 x 64 = 32 Leakage 0.5 x 32 = 16 Induced Ex = $16m Induced Ex = $8m Leakage 0.5 x 16 = 8 Slide 13 The importance of MPC and MPL

14. (c) Andrew Tibbitt 2017 The process stops when induced leakages have built up to equal the autonomous spending change. Y = $64m Induced Ex = $32m Y = $32m Y = $16m Ex =$64m Leakage 0.5 x 64 = 32 Leakage 0.5 x 32 = 16 Induced Ex = $16m Induced Ex = $8m Leakage 0.5 x 16 = 8 + + …= Slide 14 When does process stop?

15. (c) Andrew Tibbitt 2017 For complex (5 sector) economy use the formula: K = ____ 1 ____ = ________ 1 _______ 1 – mpc ( mps + mpm + mpt ) For simple (3 sector) economy use the formula: K = ____ 1 ____ = ________ 1 _______ 1 – mpc ( mps ) Slide 15 Value of the Keynesian multiplier

16. (c) Andrew Tibbitt 2017 AEx2 income E xpenditure 45 o Ex = Y AEx1 50 100 175 350 income E xpenditure 45 o Ex = Y AEx1 AEx2 100 150 175 275 Autonomous spending up by 50 - Steep AEx line – big MPC – big multiplier Autonomous spending up by 50 -Shallow AEx line – smaller MPC – smaller multiplier Slide 16 Big and small multipliers

17. (c) Andrew Tibbitt 2017 Don’t confuse the autonomous spending change with the multiplier coefficient! Autonomous spending change Marginal propensity to consume Multiplier coefficient (number) Change in economic activity $64b $25b $100b 0.75 0.75 0.50 4 4 2 $256b $100b $200b Slide 17 WARNING!

18. (c) Andrew Tibbitt 2017 36 48 16 64 64 12 27 36 20.25 48 27 20.25 5.06 9 6.75 15.19 Autonomous (new) spending 1 2 FINAL TOTAL 3 4 5 6 15.19 11.39 3.40 256 (64 x 4) 64 192 (256 – 64) Extra income Extra spending MPC = 0.75 Extra leakages MPL = 0.25 Slide 18 Showing multiplier process on a table

19. (c) Andrew Tibbitt 2017 16 32 32 64 64 16 8 16 4 32 8 4 2 8 4 2 Autonomous (new) spending 1 2 FINAL TOTAL 3 4 5 6 2 1 1 128 (64 x 2) 64 64 (128 – 64) Extra income Extra spending MPC = 0.50 Extra leakages MPL = 0.50 Slide 19 Showing multiplier process on a table

20. (c) Andrew Tibbitt 2017 income expenditure 45 o Ex = Y AEx1 AEx2 100 150 175 275 Assume $275b is full employment level of income. At AEx1 equilibrium income is only $175b There is a GDP, recessionary ( or output) gap of $100b The government only needs spend $50b to close the GDP gap because there will be a multiplier effect The $50b spending shortage is called the DEFLATIONARY GAP Slide 20 Closing a deflationary gap

21. (c) Andrew Tibbitt 2017 income expenditure 45 o Ex = Y AEx3 AEx2 200 150 275 Assume $275b is full employment level of income. At AEx3 equilibrium income is $375b There is $100b beyond the economy’s potential GDP The government only needs to cut spending by $50b to close the GDP gap because there will be a multiplier effect The $50b excess spending is called the INFLATIONARY GAP 375 Slide 21 Closing an inflationary gap

22. (c) Andrew Tibbitt 2017 S pending and tax multipliers T he government decides to build a rail link to Perth Airport. It will cost 2b and will be built by 2020. Assume MPC is 0.5. The multiplier (k) is 2. The final impact on the economy will be to raise GDP by $4b T he government decides to reduce tax by $2b . Disposable incomes rise by $2b Assume the MPC = 0.5. C onsumption falls by $1b The multiplier (k) is still 2 . The impact on the economy is to raise GDP by $2b Slide 22

23. (c) Andrew Tibbitt 2017 Tax multiplier = = 1 - 1 1 - mpc Spending multiplier – 1 Spending multiplier = 1 1 - mpc Slide 23 S pending and tax multipliers The tax multiplier coefficient is always one less than the spending multiplier coefficient

24. (c) Andrew Tibbitt 2017 Therefore, equal changes in tax and government spending leave the budget balanced but change the level of economic activity The size of the ‘balanced budget multiplier’ is always 1 The change in economic activity (GDP) always equals the size of the tax/government spending change (regardless of the size of the MPC). Slide 24 The balanced budget multiplier

25. (c) Andrew Tibbitt 2017 Estimating the size of the multiplier Suppose on average in Australia 25% of spending is on imports 25% of income goes on tax 10% of income is saved T he marginal propensity for leakages is 0.60 T he multiplier, therefore, is 1/ 0.6 or 1.67 Comment on this estimate. Slide 25

26. (c) Andrew Tibbitt 2017 Estimating the size of multiplier effects in the real world is difficult. D ifferent groups in the economy have different patterns of spending and saving. Changes in inflation may reduce spending elsewhere in the economy T he economy might be close to capacity or potential GDP L ots of different autonomous spending changes happen at the time Slide 26 Estimating the size of the multiplier

27. (c) Andrew Tibbitt 2017 Ex =$64m Y = $64m Induced Ex = $51.2m Y = $51.2m Y = $35.8m MPL = 0.2 Mr Red has low income, can’t afford to save, pays little tax and buys few luxury imports Mr Green has average income, doesn’t save much, pays a bit more tax and buys some imports MPL = 0.3 Induced Ex = $35.8m Mr Yellow has above average income, saves a bit, pays more tax and buys his share of imports MPL = 0.45 Induced Ex = $19.7m Total rise in spending from Blue, Red, Green and Yellow = $170.7m Mr Blue is the Minister for Social Security – he increases welfare payments to low income households Slide 27

28. (c) Andrew Tibbitt 2017 Ex =$64m Y = $64m Induced Ex = $16m Y = $16m Y = $8m MPL = 0.75 Mr Red sells machinery and equipment to BHP Biliton – this is mostly imported Mr Green owns shares in Mr Red’s business – he lives in City Beach, saves, pays tax and goes on overseas holidays MPL = 0.5 Induced Ex = $8m Mr Yellow is Mr Green’s travel agent – he has average income and buys an imported car with his extra income MPL = 0.45 Induced Ex = $4.4m Total rise in spending from Blue, Red, Green and Yellow = $92.4m Mr Blue is CEO of BHP Biliton - a mining company in Australia Slide 28

29. (c) Andrew Tibbitt 2017 Although the multiplier ‘ripple’ process goes on and on the size of each ripple gets smaller and smaller each time. The bulk of the changes in economic activity happen early on in the process. How long does it take for someone to receive income and then spend some of it? Slide 29 How quickly does this happen?

30. (c) Andrew Tibbitt 2017 Simple multipliers only exist in theoretical 3 sector economies. Complex multipliers happen in more realistic 5 sector economies. Super-multipliers happen when the autonomous spending change and subsequent change in real GDP cause further autonomous spending changes. Slide 30 Super multipliers

31. (c) Andrew Tibbitt 2017 Autonomous spending change Rise in real GDP Rise in investment multiplier accelerator which is another The multiplier – accelerator interaction causes cumulative processes in the economy (or economic instability) and is at the heart of the economic cycle Slide 31 Super multipliers

32. (c) Andrew Tibbitt 2017 And finally… For a full multiplier effect the autonomous spending change has to be permanent. I f spending quickly drops back to its former level, this will start a negative multiplier process which wipes out most of the initial positive multiplier process. Slide 32 One-off and permanent spending changes

33. End of slide show (c) Andrew Tibbitt 2017 Slide 33