Chapter 47: HL extension the Keynesian multiplier (2.3)

Transcription

1 Chapter 47: HL extension the Keynesian multiplier (2.3) HL extensions Circular flow revisited Calculation of the multiplier (k) Diagrammatical illustration Evaluation of the multiplier The nature of the Keynesian multiplier 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 formulae or 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 Q: How many Keynesian economists does it take to change a light bulb? A: All. Because then you will generate employment, more consumption, shifting aggregate demand

2 Circular flow revisited The multiplier is a key component of Keynesian theory, and shows the possibility of a given increase in injections i.e. government spending, investment and exports increasing aggregate demand by more than the initial value. This is quite logical at an intuitive level since an increase in, say, investment might create employment opportunities in firms producing capital, whereupon newly hired labourers will receive income which is used for consumption which increases demand for goods and ultimately more capital to produce the goods. Keynes posited that the main influence on consumption was income; or rather that consumption was a function of income. Given that households have a marginal propensity to consume, an initial increase in aggregate demand caused by an increase in injections (investment, government spending and exports) would cause increased flows in the economy leading to larger final aggregate demand and national income. Figure 47. Circular flow and the Keynesian multiplier Leakages (0.4) Foreign sector Round 2: 20 bn. Round 3: 2 bn. Round n. Financial institutions Govt. M S T Total increase in Y: Households C = 30 bn C = 8 bn Round : 50 bn. Round 2: 30bn. Round 3: 8bn. Firms Round : 50 bn. Round bn. = 80 bn. Round bn. = 98 bn. C...n Round n..? Round n +?. Final increase =? Wages, Round : 50 bn. rents, Round 2: 30 bn. interest Round 3: 8 bn. and profits Round n. The multiplicative effect shows how much final expenditure will be as a result of an initial increase in injections. This gives us a ratio, Y/ J, which is the value of the multiplier. In the example here, when the

3 government primed the economy by increasing government spending by 50 billion and aggregate demand as a result ultimately increases by 25 billion, then the initial injection has multiplied by a factor of 2.5, i.e. 25/50 billion. Calculation of the multiplier (k) The value of 25 billion in the previous example was not pulled from a hat, but calculated using the formula for the multiplier which is actually fairly straightforward, but let s go through it one step at a time. In the Keynesian model, households marginal propensity to consume, MPC, is the proportion of any increase in income used for domestic consumption. The MPC is the change in consumption over the change C 30 billion MPC = Y = billion = 0.6 (Type 4 Smaller heading) Keynesian multiplier (k) The formula for the Keynesian multiplier is; k = /MPL or k = /( MPC). Yes, the denominator is of course the same in both versions, e.g. the MPL = MPC. Version ; k = MPL 0.4 = 2.5 J ; injection (here, government spending) k ; the value of the multiplier Version 2; k = - MPC initial J x k = Final Y = 2.5 MPC ; marginal propensity to consume C / Y MPL ; marginal propensity to leak L / Y Thus; 50 billion x 2.5 = 25 billion

4 Diagrammatical illustration It probably makes intuitive sense that at very low levels of income the impact of the multiplier will be greater, since pent-up demand amongst labourers and households will lead them to spend a the greater proportion of an increase in incomes. In Figure 47.2 below, the increase in government spending shifts AD from AD0 to AD and the full force of the multiplier comes into play, e.g. final output increases from 00 to 250. Figure 47.2 The Keynesian multiplier at different levels of income Price level (index) P5 AS The multiplicative effect on AD is zero when all factors are occupied and the economy is operating at the full employment level of output. P4 P AD3 AD5 AD4 The multiplicative effect is lessened as the economy approaches full employment. AD2 AD0 AD GDPreal/t At low levels of income the full value of the multiplier (2.5) feeds through the economy. Evaluation of the multiplier There is an obvious appeal of the multiplier in demand-management since a government will theoretically be able to calculate a larger final increase in GDP than initial government spending. In fact, governments have counted on multiplicative effects in utilising demand-side fiscal policies in order to achieve balanced budgets in spite of deficit spending over a business cycle. The multiplicative increase in income has been factored-in when deficit spending and/or reduced taxation has been undertaken. This brings us to an additional reason for the reduced influence and therefore use of fiscal policies during the 970s and 80s, namely the increased openness and ease of trade between countries. Lower barriers to trade such as tariffs and quotas, plus deregulation of financial markets increased the ability of households to consume goods from abroad. Increasingly goods and services could be purchased via import, which meant that any given increase in stimulatory government spending would be withdrawn from the domestic flow of economic activity. The increase in the marginal propensity to import i.e. leakage meant a corresponding fall in the value of the multiplier, hence a decrease in the effectiveness of fiscal policies aimed at creating a multiplicative effect by way of increasing disposable income. I have indexed the starting values for the sake of illustrative simplicity. I have also assumed that taxes and imports are zero!

5 Another obvious line of criticism is the simple fact that governments need to raise money in order to increase government spending. There are some serious trade-off effects here: Increased government debt is a burden on future households and might lead to higher taxes. Deficits and debt both have consequences on the exchange rate in the long run. Higher debt ratios (as a percentage of GDP) are clearly linked to weaker currencies. (See Chapter 67.) If the government borrows money on the open market there will be an effect on the rate of interest the cost of borrowing money rises in the economy. This might cause a crowding out of private sector investment as firms scale back investment plans due to higher costs of funding loans. The decrease in investment will have a dampening effect on aggregate demand. (For full explanation see Chapter 57.) Pop quiz: Keynesian multiplier. In an economy, government spending increases by $0 billion and final income increases by $25 billion. What is the value of the MPC? 2. If government spending increases by 0 billion and the marginal propensity to consume (MPC) is 0.5, what will the final increase in national output be? 3. How will an increase in the marginal propensity to save (MPS) affect the multiplier? 4. Looking ahead: How might the creation of a common market (see Chapter 74) affect individual countries ability to rely on multiplicative effects in using fiscal policies to stimulate the domestic economy? 5. Evaluate the extent to which an increase in government spending might have multiplicative effects e.g. what might strengthen or weaken the impact on final output?

6 Summary and revision. In the circular flow model, injections (J) are I, G and X. Leakages (L) are S, T and M. 2. Government spending is a component of AD. The Keynesian multiplier shows how an increase in government spending results in a final increase in GDP that is greater than the initial amount of government spending. 3. The MPC is the change in consumption due to a change in income; C/ Y. 4. The MPL is the change in leakages due to a change in income; L/ Y. The MPL is comprised of: a. The marginal propensity to save (MPS) b. The marginal propensity to import (MPM) c. The marginal propensity to tax (MPT) d. Hence, the MPL is the sum of MPS, MPM and MPT 5. The Keynesian multiplier (k) is given by: a. /MPL, or b. /-MPC 6. MPC + MPL =. If households spend 60% of any increase in income then the MPC is 0.6 and the MPL is The multiplier works better at low levels of income than at high levels. 8. Weaknesses in using the multiplier include: a. Increased openness in trade increases the MPM b. Marginal tax levels in many countries have increased the MPT c. Governments might finance spending via increased deficits and debt which can have adverse effects on taxes, inflation and exchange rates d. Government borrowing might lead to higher interest rates and crowd out private sector investment which is a component of AD.