A2 Multiplier: multiple-choice question

Following on from my last post on the multiplier, below is a type of question which has been quite popular in the last couple of exam sessions. I have changed the data from the original CAIE question.

The table shows the values of selected macroeconomic variable over a two-year period.

What is the value of the multiplier?

A. 3 – B. 4 – C. 6 – D. 12

From the data both years are in equilibrium
Year 1 NI = 3800  –  Injections = 260+160+200 = 620 Withdrawals = 300+140+180 = 620
Year 2 NI = 4600  –  Injections = 360+210+250 = 820 Withdrawals = 350+210+260 = 820
 
The increase in injections has been 200 but the increase in NI has been 800 (4600-3800) – therefore the multiplier is 4 – (4 x 200 = 800).

The Multiplier
Consider a $300 million increase in business capital investment. This will set off a chain reaction of increases in expenditures. Firms 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 realise 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 value of the multiplier can be found by the equation ­1 ÷ (1-MPC)
You can also use the following formula which represents a four sector economy
1 ÷ MPS+MRT+MPM

Source: CIE A Level Revision Guide – Susan Grant

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A2 Economics – Multiplier

Just been looking at the multiplier with my A2 class and here are some notes and a mindmap. An initial change in AE 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.

Multiplier Process

Consider a $300 million increase in business capital investment. This will set off a chain reaction of increases in expenditures. Firms 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 value of the multiplier can be found by the equation ­1 ÷ (1-MPC)

You can also use the following formula which represents a four sector economy

1 ÷ MPS+MRT+MPM

MPS = Marginal propensity to save

MRT = Marginal rate of tax

MPM = Marginal propensity to import

MPC = Marginal Propensity to Consume (of additional income how much of it spent)

e.g. $1m initial spending; MPC=.8

=> income generated = 1/(1-.8) = 1/.2 = 5

=   $5m

=> $4m extra spending ($1m initial, $4m extra spending, $5m total)

Use different equations depending on the information given.

e.g.: a) if the MPC is 0.5 – 50% of the income will be spent, 50% will be saved.

then MPS is 0.5 then the multiplier is 2 = 1/0.5 = 2

b) if the MPC is 0.8 – 80% of the income will be spent then MPS is 0.2 then the multiplier is 1/0.2 = 5

c) if the MPC is 0.9 – 90% of the income will be spent then MPS is 0.1 then the multiplier is 1/0.1 = 10

What is the effect of MPT – the marginal propensity to tax or t.

• greater MPT would lead to less income being spent in the economy

Below is a very informative mind map that I copied from an old textbook.

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The America’s Cup: multiplier effect and cost-benefit analysis

Source: RNZ

I was fortunate enough to be out in the spectator fleet for yesterday’s America’s Cup racing between Emirates Team New Zealand and Luna Rosa Prada Pirelli – honours were even in the two races. As with most events, analysts attempt to work out the multiplier effect and the impact it will have on an economy. In 2017 forecast, predicted that the America’s Cup would add between $600 million and $1 billion to the New Zealand economy. Employment would be boosted and in the longer term for every $1 put into infrastructure would generate $7.50 of economic activity. However with the impact of COVID-19, New Zealand will suffer a loss on the $249.5 million it invested in the America’s Cup, but there maybe benefits over time.

The Multiplier Explained

Consider a $300 million increase in business capital investment. This will set off a chain reaction of increases in expenditures. Firms 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 realise 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 value of the multiplier can be found by the equation ­1 ÷ (1-MPC)
You can also use the following formula which represents a four sector economy
1 ÷ MPS+MRT+MPM

Source: CIE Revision Guide by Susan Grant

The economic impact is based a lot on the multiplier effect but the use of cost benefit analysis also considers those external costs and benefits which are not easily convertible into a monetary value.

Evaluation of CBA
It is clearly more efficient for public spending to be subject to rigorous analysis, rather than based on the whims of politicians. However, there are a number of criticisms of CBA, including:

1. It is often very costly to undertake, though usually this forms a very small proportion of total project spending.
2. Assessing the monetary value of external costs and benefits is often very difficult. What precisely is the value of the congestion that would be reduced if a new bi-pass were built around a busy town? How much extra tourist revenue will actually be gained from a new airport? How long will the building be used as a venue, as in the case of the Viaduct area in Auckland for the 2020/21 America’s Cup. One solution to this problem is shadow pricing, where analysts attempt to place a value on the costs and benefits of a decision or a project where an actual market price does not exist.
3. Changing circumstances can make initial projections appear grossly inaccurate. The Wembley Stadium project in London went considerably over-budget, and the majority Olympic Games are far more costly than originally estimated. For instance the Montreal Olympics in 1976 was eventually paid off in December 2006. Higher interest and inflation rates, and falling exchange rates can all dramatically affect costs.
4. Actual costs can also rise above planned costs as a result of moral hazard, where project managers go over budget because they expect that those who fund the project will make extra funds available, providing an insurance against their over-spending.
5. Ultimately, decisions to go ahead with projects are only guided by CBA, leaving politicians to make the final decision. Politicians are free, of course, to ignore the results of an appraisal.

If you have read the book Circus Maximus you will no doubt be aware that most big sporting events run over budget and in some cases don’t generate the benefits until well after the event if at all. So just because an event runs over budget is that enough to say that we shouldn’t go ahead with the event. There are a great many other benefits of hosting an event like the Americas Cup which are not measured by GDP. The sense of community and wellbeing that comes from New Zealander’s performance whether it be in rugby or at the Olympics. It tends to bring people together feel a sense of belonging which has external benefits.

Keynes v Monetarist – Powerpoint download

Here is a powerpoint on “Keynesian and Monetarist Theory” that I use for revision purposes. I have found that the graphs are particularly useful in explaining the theory. The powerpoint includes explanations of:

– C+I+G+(X-M)
– 45˚line
– Circular Flow and the Multiplier
– Diagrammatic Representation of Multiplier and Accelerator
– Quantity Theory of Money
– Demand for Money – Liquidity Preference
– Defaltionary and Inflationary Gap
– Extreme Monetarist and Extreme Keynesian
– Summary Table of “Keynesian and Monetarist”
– Essay Questions with suggested answers.

Hope it is of use – 45˚line shown. Click the link below to download the file.
Keynes v Monetarist Keynote

A2 Economics: Tutor2u Webinar – Multiplier and Accelerator

Here is an excellent webinar by Geoff Riley of Tutor2u on the multiplier and accelerator. This is part of Unit 5 in the CIE A2 course. Although the examples that he talks about are UK based he explains the theory very well. Worth a look especially with mid year exams approaching.

The Fiscal Multiplier – does austerity raise growth levels?

Free Exchange in The Economist debated this topic and went into detail concerning the Fiscal Multiplier. It refers to the change in GDP that is due to a change in government fiscal policy – taxes and spending. They use the following examples

Multiplier = 1.5 Government Spending down $1 = overall spending down = $1.5
Multiplier = 0.5 Government Spending down $1 = overall spending down = $0.5

Therefore the value of the multiplier is the crucial variable and a value that is greater than the level of GDP you maybe able to close the deficit but this results in a higher debt to GDP ratio than it started with. Estimates of the fiscal multiplier have been approximately 1% or below and the IMF have suggested that if you cut deficits by 1% of GDP it will have an impact of 0.5% of GDP – multiplier value of 0.5. What has been suggested is that:

Spending cuts may “crowd in” private-sector activity: if governments are using up scarce capital and labour then austerity creates room for private firms to expand. In open economies, austerity’s bite can be passed on to other countries through reduced imports. Most important of all, monetary policy can act as a counterweight to fiscal policy. Spending cuts that threaten to drag growth below a desired level should prompt monetary easing, limiting the multiplier.

However timing is everything and austerity measures now are not conducive to favourable outcomes for the following reasons:

1. With many economies implementing the same measures the impact can’t be deflected onto others.
2. Austerity measures normally might free up resources for private use but that mattered far less when unemployment and saving were high.
3. With interest rates at near-zero levels there was little scope for any additional monetary stimulus to offset the fiscal tightening. Monetary policy has run out of ammunition.

Olympics Boost for UK economy by £16.5bn

Patrick Foley, Chief Economist at Lloyds Banking Group, recently wrote in The Daily Telegraph (UK) that the Olympic Games in London will boost the UK economy by £16.5bn. He sees construction, tourism, jobs and the ‘happiness’ effect will leave a lasting legacy.

The development of a neglected area of East London will have a huge impact with higher living standards and business opportunities. There are also huge tourism benefits that follow from the end of the games and this has been prevalent with most host cities in the past. The Games could create and support a total of 354,000 years of employment across the UK. Jobs that are directly associated with the Games themselves and through developing skills of the working population that help raise their prospects of jobs in the future.

There is also the ‘happiness effect’ with hosting one of the biggest sporting events which is likely to inspire consumer spending. A number of economists have looked at the economic impact of hosting significant sporting events and are in broad agreement that aggregate demand does increase. In 1996 when England hosted the European Football Championship it was estimated that the feel-good factor was equivalent to £165 gift for each of the UK population – it can be expected the London Olympics will be significantly higher than this figure.

Fall in Global Dairy Prices and Multiplier Effect.

Recently prices on Fonterra’s global dairy auction fell but analysts feel that this is not going to be long-term. The fall has been mainly caused by:

Supply increasing significantly relative to the demand – March, April and May tend to be very productive for northern hemisphere farmers as that is when they have peak supply figures. Furthermore over the summer in New Zealand we have had excellent growing conditions with soil moisture levels being very high for the time of year. This transfers into an increase in available feed for dairy units and increased milk output.

The graph below shows the Global Dairy Trade Weighted Average Prices and it is believed that this drop in prices is not a re-run of the global financial crisis when prices dropped to below US$2,000 a tonne. This was due to stagnant demand which does not seem prevalent today.

It is estimated that a US$1 difference in the milk price between seasons represents about $1 billion in cash flow for Fonterra’s 10,000 supply farms. When you consider the multiplier effect this can translate to 4 times that for the rural sector as a whole.

The Multiplier

An initial change in aggregate expenditure 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.

Multiplier Process
Consider a $300 million increase in business capital investment. This will set off a chain reaction of increases in expenditures. Firms 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 value of the multiplier can be found by the equation 1 ÷ (1-MPC)

You can also use the following formula which represents a four sector economy
1 ÷ MPS+MRT+MPM

MPS = Marginal propensity to save
MRT = Marginal rate of tax
MPM = Marginal propensity to import

Economic Impact of a University

Michael Cameron – Senior Lecturer in the Economics Dept at the University of Waikato in Hamilton – presented a paper on The Economic Impact of a University. In order to work this out he estimated the size of the multiplier using an input-output model.

But what is the multiplier effect?

$1 of spending in an industry generates more than $1 of total output for the economy. Why?
* That $1 becomes income for the firm that receives it. They will use some of that to pay their suppliers
* Those payments become income for the suppliers, who in turn will use some of that money to pay their suppliers and so on (we refer to these as backward linkages)
* There are also forward linkages (to firms that receive the output from that sector)
* And of course some of the income goes to workers as wage/salary and they save some but spend some too
* All of that adds up to more than $1 of production
*The value of the multiplier can be found by the equations:
– 1 ÷ (1-MPC)
– 1 ÷ MPS+MPT+MPM

To estimate the size of the multiplier effects, economists typically use an input-output (I/O) model. How is this constructed?

*This is an industry-by-commodity matrix which basically shows, for every commodity produced by the economy, which industries supply it (or if it is imported), and which industries use it (or if it is used by households/government as final demand, or if it is exported)
*That gives the basic structure of the economy, which with some wizardry we can construct and industry-by-industry input-output table from.

What is the impact of the university?

Michael Cameron found the following results and values of the multipler for each section.

How much is the Rugby World Cup worth to NZ?

Thanks to Andrew Larkey for alerting me to this article from the BBC website. A report from Mastercard has come up with some interesting stats regarding the impact of the Rugby World Cup on the New Zealand economy. The overall value to the economy could be as much as NZ$1.45bn

Rugby World Cup 2011
– NZ$272.5m in ticket revenues
– NZ$$247.8m to be spent on accommodation
– NZ$$227.8m to be spent on food and drink
– 7.5 million litres of beer to be poured
– 7.35 million pies and sausages to be eaten
-150,000 litres of sports drinks to be consumed

About 95,000 international fans are expected during the course of the tournament.

“In terms of economic impact, the most important component is international visitors as they contribute money to the economy that would not have otherwise been spent in New Zealand. Such activity could increase to NZ$14.2bn by the end of the decade.” the report said.

Along with its direct economic benefits, the Rugby World Cup is also likely to boost the value of New Zealand as a brand. The America’s Cup sailing in 2000 generated almost NZ$$91.4m in brand value for the country. Lets wait and see – maybe if New Zealand wins there will be even a greater impact on the economy. In all this it would be interesting to try and work out the value of the multiplier. Any ideas? Go Ireland!