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Multiplier (HL only)

Introduction

This lesson focuses on the multiplier - one of the most important components of understanding keynesian economic theory.

Enquiry question

What is the multiplier in economics and how is it calculated?

Lesson time: 1 hour

Lesson objectives:

Explain, with reference to the concepts of leakages (withdrawals) and injections, the nature and importance of the Keynesian multiplier.

Calculate the multiplier using either of the following formulae: 1 / (1− MPC ) or 1 / (MPS + MPT + MPM).

Use the multiplier to calculate the effect on GDP of a change in an injection in investment, government spending or exports.

Draw a Keynesian AD/AS diagram to show the impact of the multiplier.

Teacher notes:

1. Beginning activity - begin with the opening 'multiplier' game and  allow 15 minutes in total for this - longer if needed.

2. Processes - technical vocabulary - the students can learn the background information from the opening video and the first activity. (20 minutes) 

3. Applying the calculations - complete the short response activities on activity 2, which involve multiplier calculations.  (10 minutes)

4. Developing the knowledge - activity 3 develops the argument, with a video that illustrates the term 'crowding out'. Show the video and then have your classes complete the two short questions that follow.  (10 minutes)

5. Final reflection - activity 4 is probably most effectively completed as a discussion or group discussion - does 'crowding out' make the multiplier irrelevant?  (5 minutes)

Beginning activity

Begin this lesson with a simple game to help your classes understand the way that the multiplier works.  Make up goods and services cards as well as fake money and distribute the goods and services to your students = but not the fake money.  Each student will now have a card with the good or service that they are able to produce and sell written on it. 

Start with a simple trading system but of course virtually no trading (if any) can take place because of a shortage of cash.  This is similar to the situation in which economies find themselves in during a recession. 

Now distribute $ 1,000 of fake money to a small number of your class, instructing them to spend this on the goods and services that their friends possess.  Your students should see that once the cash starts to be spent it quickly gets circulated around the room, purchasing multiple goods and services as it does.  Record the total rise in spending derived as a result of the $1,000 into the circular flow. 

Next distribute an additional $ 1,000 and similarly record the total increase in activity.  You can continue tis process until the injection of cash stops being effective.

End this game with a discussion on the concepts learnt - multiplier, MPC e.t.c.

Key terms:

Leakages from the circular flow - leakages out of the economy from savings, taxes, and imports.

Injections into the circular flow - injections into the economy from investment, government purchases, and exports.

Marginal propensity to consume (MPC) - represents the proportion of any additional income earned that is consumed on domestically produced goods and services.

Marginal propensity to save (MPS) - represents the proportion of any additional income earned that is saved.

Marginal propensity to import (MPM) - represents the proportion of any additional income earned that is consumed on goods and services produced overseas.  MPM and MPS along with tax represent money which leaks out of the circular flow of income and reduce the effectiveness

Multiplier - the factor by which any increase in total output is greater than the initial change in initial spending.  It is calculated by the formulae 1 / (1 - MPC).

The activities on this page can be downloaded as a PDF at:  The multiplier

Activity 1: Multiplier

Using the information contained in the video complete the activities which follow:

Questions:

1. What is the multiplier?

The multiplier is the factor by which any increase in total output is greater than the initial change in initial spending.  It is calculated by the formulae 1 / (1 - MPC).

2. Illustrate the impact of the multiplier on an AD / AS diagram.

The initial equilibrium is represented by the intersection of AD1 and SRAS.  Following the government stimulus AD rises to AD2, with the effect of the multiplier increasing the total increase in aggregate demand to AD3. 

3. The diagram to the right illustrates a simple circular flow diagram.  Redraw the diagram indicating the leakages and withdrawals from the circular flow diagram.  Explain why the size of the leakages and withdrawals determines the size of the multiplier?

When the government injects money into the circular flow in the form of government spending, multiplier theory dictates that some of this will be spent on domestically produced goods and services, while a portion will leak out in the form of savings, tax and imports.  The smaller this proportion the greater the proportion that circulates around the economy, increasing the size of the multiplier.

4. Why did Maynard Keynes believe that increasing government spending was a more effective way of using the multiplier than reducing taxes or interest rates to stimulate the economy? 

Maynard Keynes believed that while lowering taxation or interest rates could increase economic activity in the economy, this method was likely to be less effective than increases in government spending.  This is because there is no guarantee that consumers would spend their new earned income on domestically produced good and services.

Activity 2: Calculating the effectiveness of the multiplier

(a) An economy is in recession and is producing at around $ 40 billion below the economies productive capacity.  This means that the economy has an output gap or deflationary gap of $ 40 billion.  The government understands from previous downturns, that households on average will spend half of any additional income gained on domestic goods and services.  The government commits to a programme of $ 20 billion in extra spending and lower taxes.  Will the $ 20 billion investment be sufficient to fill the output gap?

Yes the government is able to fill the $ 40 billion deflationary gap with an increased spend of only $ 20 billion and with the government receiving a % of any additional income generated in tax, the government may receive a sizeable proportion of the initial investment back.  This all presumes that 50 % of the additional income received does go back into the economy and that crowding out does not occur – i.e. the additional jobs created do not simply replace private sector positions elsewhere in the economy.

(b) An economy has an MPC of 0.7.  There is an output gap in the economy equivalent to $ 100 billion.  In order to bring the economy back to its full employment level, how much should the government inject into the economy?

The size of the multiplier is calculated by 1 / (1 - MPC).  In other words the multiplier is 1 / 0.3 = 3.33 so in order to close an output gap of $ 100 billion the government must inject $ 30.03 billion into the circular flow.

(c) The United Kingdom has a marginal propensity to save of 0.05 and a marginal propensity to import of 0.2.  By contrast households in Belgium save 14% of their disposable income and spend 60% of their disposable income on imported goods and services.  Which of these two nations is the multiplier more effective? 

In total households in the UK spend 75% of their income on domestically produced goods and services, meaning a marginal propensity to consume of 0.75.  Belgium households by contrast have a marginal propensity to consume of just 0.26.  The size of the multiplier for each nation therefore is 4 for the UK and just 1.35 in Belgium, making any fiscal stimulus package in that nation less effective.

Activity 3: Crowding out

Use the information included in this short video to answer the questions below:

(a) To what extent is ‘crowding out’ likely to reduce the effectiveness of any Keynesian stimulus package?

This depends entirely on whether you are considering the response from a keynesian or monetarist perspective.  Keynesian economists do not discount the importance of crowding out but believe that it will only partially reduce the effectiveness of a stimulus package.  Free market / laissez faire economists believe that there will be 100% crowding out in the long run, although many accept that a stimulus package may bring about improvements to national income in the short run.

(b) What factors are likely to determine the amount of crowding out in the economy?

The level of spare capacity is in the economy.  At high rates of unemployment, among all factors of production, crowding out is unlikely but as the economy reaches its production possibility frontier the degree of crowding out, as those resources become scarcer, is more likely.

Activity 4: Final reflection

Based on what you have learnt during this lesson, do you believe that 'crowding out' will inevitably mean that any rise in government will ultimately lead to higher debt and no significant rise in national income?

Hint:

This depends on the level of spare capacity in the economy but it may also be effective if the rise in public spending leads to a more efficient use of the country's resources e.g. a worker with low productivity is given a public sector job where their marginal output is higher.