An initial change in AD can have a greater final impact on equilibrium national income. This is known as the multiplier effect and it comes about because injections of demand into the circular flow of income stimulate further rounds of spending.
The Multiplier Process
Consider a £300 million increase in business investment. This will set off a chain reaction of increases in expenditures. Those who produce the capital goods that are ultimately purchased will experience an increase in their incomes. If they in turn, collectively spend about 3/5 of that additional income, then £180m will be added to the incomes of others.
At this point, total income has grown by (£300m + (0.6 x £300m). The sum will continue to increase as the producers of the additional goods and services realize an increase in their incomes, of which they in turn spend 60% on even more goods and services. The increase in total income will then be (£300m + (0.6 x £300m) + (0.6 x £180m).
The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow.
The Multiplier and Keynesian Economics
The concept of the multiplier process became important in the 1930s when Keynes suggested it as a means to achieving full employment. This demand-management approach, meant to help overcome a shortage of business capital investment, measured the amount of government spending needed to reach a level of national income that would prevent unemployment.
The higher the propensity to consume, 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 basic rate of income tax will increase the amount of extra income that can be spent on further goods and services.
Another factor affecting the size of the multiplier effect is the propensity to purchase imports. If, out of extra income, people spend money on imports, this demand is not passed on in the form of extra spending on domestically produced output.
The multiplier process also requires sufficient spare capacity in the economy for extra output to be produced. If 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. This is shown in the diagram below
ASSUMPTIONS UNDERLYING THE MULTIPLIER EFFECT
Marginal propensity to import
The multiplier might ignore foreign economic effects that are important for countries with a large foreign trade sector.
Consider a rise in UK investment some of which is spent on imports. This will increase the national income of another economy and might therefore lead to a further rise in UK exports. This would have further multiplier effects.
A fall in aggregate demand
The multiplier effect works for falls in demand too. The loss of an export order or the cancellation of a planned investment project can have a negative multiplier effect on the regional or national economy.
A good example to use is the closure of a local factory, perhaps the main employer in a town. The resulting loss of employment can have severe negative effects on average incomes and spending on the rest of the community with further "knock-on" effects on suppliers and retailers.
Supply-side capacity of the economy
We have assumed that an increase in aggregate demand does lead to a rise in real national output. This is the case when the economy has the spare capacity to meet the demand, but there are occasions when any further increase in demand will create an inflationary gap.
A further assumption is that interest rates remain constant - it may well be the case that when aggregate demand is rising the central bank may take steps to curb the growth of demand by raising official interest rates
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