Introduced by Keynes in his 1936 The General Theory of Employment, Interest and Money,
the Multiplier shows by how many times an
increase in any autonomous expenditure (I, G or X)
In a way, the Multiplier is like throwing a
pebble into a pond. The initial ripple is followed by other ripples that
stretch further and further out across the pond
7th Ed Fig. 27.5;
). Thus if investment increases because firms anticipate lower interest rates or higher profits, they invest. To invest they buy factors of
production from households which therefore receive more income some of which they spend
(1st ripple). The goods and services purchased with this new household income are,
in turn, made by firms that hire more factors of production to increase
production that increases the income of other households some of which, in turn,
is spent (2nd ripple). And so on, and so on....
begin by assuming that the Aggregate Price Level is fixed in a closed economy
and the Marginal Tax Rate (MTR) is zero.
(Figure 7), the size of the Multiplier depends on the slope of AE curve,
i.e., the marginal propensity to consume or 'b'.
In a closed economy this is (1/1-b) where b = MPC and '1' represents total
disposable income. All
things being equal, the steeper the slope of the AE curve, the larger the
multiplier; the gentler the slope, the lower the multiplier (P&B
7th Ed Fig. 27.7).
Assuming b = .75 (75 cents of each additional dollar in income is spent on
consumption) then (1/1-.75) = (1/.25) = 4. It is important to note that the
Multiplier is a process spreading out over
Consumption, Income Taxes & Imports
The size of the multiplier depends on the slope of AE which, in turn, is determined by
the marginal propensity to consume (MPC), the marginal tax rate (MTR) and, in an
open economy, the
marginal rate of imports (MPM)
. All things being equal: the higher MPC,
the steeper the slope of AE; the higher MTR, the gentler the slope; the higher MPM,
the gentler the slope.
iv - Other
In addition to the general Autonomous Expenditure
Multiplier described above these include the:
a) Government Expenditure Multiplier;
b) Autonomous Tax Multiplier;
c) Balanced Budget Multiplier; and,
d) Impact of the Marginal Propensity to Import (MPM)
Government Expenditure Multiplier (GEM)
The GEM is the same as the
general Autonomous Expenditure Multiplier, i.e., GEM = 1/1-b = ∆Y/∆G.
For public policy this means an increase or a decrease in G has a multiplier
effect on GDP - up or down. Government, in other words, can use the
Multiplier like a lever to increase or decrease GDP without doing it all itself.
Thus if G increases by $50 million with a Multiplier of 4 (as above) it causes
GDP to increase by $200 million. This is true assuming a fixed Aggregate
Price Level, a closed economy and the Marginal Tax Rate (MTR) is zero. As
will be seen if P changes or we are in an open economy or the MTR is positive
then the multiplier effect is reduced.
Tax Multiplier (ATM)
There are essentially two kinds of taxes - induced
and autonomous. Induced taxes rise and fall as Y varies. In this way
induced taxes like income tax act as
automatic stabilizers of the economy. If Y goes up then the Marginal Tax
Rate rises to a higher level (progressive taxation) and disposable income is
reduced cooling the economy; if Y goes down the Marginal Tax Rate falls to a
lower level and disposable income rises.
Autonomous taxes do not vary with
real GDP but rather are determined by Government. An increase in taxes decreases
disposable income and hence consumption and therefore Y.
The decrease in Y will, however, be greater than the increase in taxes (P&B 4th
The Autonomous Tax Multiplier equals -b/1-b = ∆Y/∆T assuming a fixed
Aggregate Price Level, a closed economy and the Marginal Tax Rate (MTR) is zero.
Thus if b = .75 then ATM = .75/1-.75 = .75/.25 = 3. Thus an increase
in taxes of $50 million will lead to a decline in Y of $150 million.
The inverse of the ATM is the Multiplier associated with transfers. Transfers
are like negative taxes, i.e., taxes are reduced. The Autonomous Transfer
Multiplier is simply the negative of the ATM. Another related concept is 'tax
expenditures' where Government selectively reduces taxes and losses revenue
iii - Balanced
Budget Multiplier (BBM)
The BBM is the amount by which a
change in government expenditures is matched by a change
in autonomous taxes. The result is that the initial balance between government
revenue and expenditure (deficit/surplus) is maintained. The BBM requires
that the effect of GEM (1/1-b) should exactly offset the effect of ATM (-b/1-b)
so that ∆Y/∆G = ∆Y/∆T. This is true assuming a
fixed Aggregate Price Level, a closed economy and the Marginal Tax Rate (MTR) is
- Impact of Marginal Propensity to Imports (MPM)
If, in a closed economy, we assume a MPC of .75, i.e., 75 cents of every dollar is spent on
consumption then GEM is 1/1-.75 = 1/.25 = 4. If, however, the economy is
open and MPM is
.1, i.e., 10 cents on every dollar is spent on imported goods then, AEM is
1/1-.75-.1 = 1/.65 = 2.86. This again assumes a fixed Aggregate Price
Level and the Marginal Tax Rate (MTR) is zero
Economist study the
business cycles - the ups
and downs of the economy.
As will be seen the Multiplier plays a significant role in Government's
management of the cycle.
According to the Dictionary of Economics
and Business (Erwin Esser Nemmers, Littlefield, Adams, Totowa, New Jersey,
3rd Ed., 1976, pp. 54-5), the business cycle is:
Rhythmic changes which take place in business conditions over a period of
time. The phases of the cycle are called prosperity (peak, upswing,
expansion), crisis (down-turn), depression (trough, downswing,
contraction), and recovery (upturn, revival). Various explanations for
the business cycle have been developed. In analyzing cyclical statistics
a number of different cycles have been found, each named after the man who
developed knowledge of it. Thus the Kitchin cycle is about 40 months, the
Juglar cycle is from 8 to 14 years, the Spiethoff cycle about 20 to 30
years and the Kondratieff cycle (long wave) about 50 years.
There are a many explanations
for the business cycle including the:
animal spirits theory
interaction of multiplier & accelerator theory
weather (sunspots) theory
3.5 Aggregate Demand (MKM
Aggregate Expenditure is calculated assuming a
fixed Aggregate Price Level (P) At a given P the various economic
actors - households, firms, governments, exporters and importers - make their
Y = C +
I + G + X – M. Change P and there is
a different result. For each level of P a different level of Y exists.
Plotting all different levels of P (graph below) with corresponding levels of Y
and we can plot the Aggregate Demand Curve (ADC).
The implications of changes in P for the multiplier effect will be explored
The ADC is downward sloping.
The Law of Demand holds as in Microeconomics:
The lower the price, the higher the demand; the higher the price, the lower the
demand. Principal factors causing the
ADC to shift include:
Fiscal & Monetary Policy; and,
i - Price
All things being equal: the higher P the lower Y measured as real GDP (P&B
7th Ed Fig. 26.4;
MKM Fig 14.3). And,
as in Micro, there are income and substitution
effects associated with price changes.
In Macroeconomics, the income effect is called 'the wealth
effect'. If prices rise, wealth falls as financial assets (bank accounts, stocks and bonds) buy less.
poorer and buy less. There is movement up the ADC with declining Y and
Macro the substitution effect (shifting from the more to less expensive)
involves future prices (expectations) and foreign prices (imports).
If prices are expected to go down tomorrow people will buy less today. At
the extreme, this delay in spending can lead to
(the expectation of ever lower prices)
with associated costs including the
Similarly, if Canadian prices go up but foreign prices remain constant then
foreign prices (imports) become relatively less expensive and Canadians buy more foreign and fewer Canadian goods
& services. Domestic
factors of production are not employed and less income is earned.
At the extreme, this shift can lead to
and associated costs including the decreased potential
GDP of a Nation-State.
It is primarily expectations about future income, prices and
profits that determine aggregate demand today. The expectation of an increase
in future income leads consumers to increase aggregate demand today and
vice versa. The expectation of increase
future profits leads firms to increase their investment today shifting the ADC and
vice versa. Similarly, the expectation of
higher prices tomorrow (inflation) leads households and firms to increase
purchases today and
vice versa. Again, Keynes'
John. R. Common's
People live in the future but act in the present.
Fiscal & Monetary Policy
Fiscal policy involves taxation and government spending including
transfers to households and firms. If government spending goes up,
aggregate demand shifts up and
Taxation takes income from households to fund government spending. If taxes go down,
disposable income goes up and, all things being equal, aggregate demand shifts
vice versa. Monetary policy involves changes in the
money supply and interest rate (the
cost of money). If interest rates go down investment goes up shifting the
ADC up and
Similarly, if the quantity of money increases households, firms and/or
government can spend more shifting the ADC up and
More will be said in 5.0 Fiscal & Monetary Policy.
iv - Population
Growth or decline in population obviously affects
AD. More or fewer households generate more or less demand shifting the ADC
The Global Economy
global factors influencing domestic aggregate demand are the exchange rates ($Cdn) and foreign
income (GDPf). If the exchange rate
goes down, the dollar buys less foreign goods. Imports go down. Domestic
goods & services become less expensive to foreign buyers and exports increase.
Both cause the domestic ADC to shift up and
if foreign GDP goes up
they can buy more domestic goods & services increasing exports shifting the ADC
up and vice versa. More will be said in 6.0 The Global Economy.