 SUMMARY

# SESSION 5: MULTIPLIER EFFECTS AND THE ACCELERATOR PRINCIPLE

Keynesians emphasize that initial changes in investment expenditure, government expenditure, and expenditure on exports and imports have a multiplicative effect on changes in national income (and, by extension, real GDP) and that this effect can be estimated broadly. This results in one of the most essential concepts in Keynesian macroeconomic analysis.

This is the multiplier for the national Income. This presentation will elaborate on this concept and the accelerator principle

Objectives By the end of this session, readers should be able to do the following:

1. explain what the multiplier effect is and its importance
2. understand the accelerator principle

Changes in any component of aggregated planned expenditure will affect the level of national income (Ye) at equilibrium.

For instance, a change in any of the injections into or leakages from the circular movement of income will affect economic activity.

The multiplier effect measures the degree to which a change in an injection or leakage affects the national income.

## 5.1 Meaning of Multiplier Effect.

The multiplier effect is defined as the ratio of the resultant change in national income with respect to the initial change in injections or leakages.

This gives rise to measures such as the government expenditure multiplier (∆ Y/∆G), investment expenditure multiplier (∆Y/∆I), and the export multiplier (∆Y/∆X), where, as before, ∆ means ‘change in’ or increment. In more general terms, the size of the multiplier can be calculated as

Size of multiplier =      change in national income

The initial change in aggregate expenditure

This would be clarified using one of the components of total expenditure. For instance, if the government decides to raise its level of spending, aggregate planned spending in the economy would increase, as depicted in the graph below.

The increase in G is depicted as a vertical movement from AE1 to AE2 in aggregate planned expenditures. Consequently, an initial increase in government spending has resulted in a new equilibrium level of national income Y*.

It is essential to note, however, that the initial increase in government spending is less than the subsequent increase in national income (G Y). To discover how the value of the multiplier is derived, let us take a simple case in which the only leakage from the circular flow of income is saving, that is, all income is either spent (consumed) or saved. Thus, it follows directly that for any change in national income:

mpc + mps = 1 In this simple case, therefore, the multiplier will depend upon the mps and may be measured as follows

Multiplier =  1           =1

Mps          1-mpc

In addition to savings, the other two leakages from the circular flow (taxation and import-related expenditures) typically influence the magnitude of the multiplier. Consider what occurs when firms increase their investment expenditure (I) in order to grasp this concept.

This will result in an increase in national income (output or real GDP), which will stimulate consumer expenditure (C). However, a portion of the increase in I and C will be spent on imported products and services rather than those produced domestically.

Thus, the greater the marginal propensity to import, the lesser the ultimate change in domestic economic activity caused by an injection into the circular flow.

Likewise, income taxes diminish the magnitude of the multiplier effect. Assume, as before, that there has been an injection into the economy as a consequence of an increase in I, resulting in a higher initial level of national income.

If income taxes are raised, disposable income will increase less than total income, and as a result, C will increase less than it would have otherwise.

The higher the marginal tax rate, the lesser the change in disposable income and real GDP resulting from a circular flow injection.

In practice, the magnitude of the multiplier is determined by the marginal propensity to save, the marginal rate of tax, and the marginal propensity to import. Thus, in the more comprehensive case, the multiplier can be defined as follows:

Multiplier =  1

Total Leakage

Where the total leakage comprises the marginal propensity to save, the marginal rate of tax, and the marginal propensity to import.

## 5.2 A ‘Demultiplier’ Effect

A ‘demultiplier’ effect will also arise when we have a reduction in any of the injections I, G and X. A reduction in aggregate planned expenditure will lead to a multiplied reduction in national income, based on the analysis as set out above.

## 5.3 Importance of the National Income Multiplier

1. The appreciation of the multiplier effect helps industries to plan ahead. For instance, decisions by the government to build new roads have a significant impact on directly related industrial sectors, such as the various construction industries.
2. It also provides a simple but useful quantitative guide for the government in assessing the impact of policy measures on the economy.
3. It helps the government in deciding how much demand should be lowered or raised in order to reduce or increase national income to the desired level.

## 5.4 The Accelerator Principle

This session’s discussion focused on elucidating why an increase (or decrease) in injection into the circular flow of income will result in an increase (or decrease) in the national income level.

After accounting for leakages, the ultimate change in the level of economic activity will hinge on the magnitude of the corresponding multiplier effect. In the case of an increase in net investment expenditure (i.e., gross investment minus an allowance for depreciation or replacement investment), however, another important principle must be taken into consideration. This principle is referred to as the accelerator principle.

The accelerator principle relates the quantity of net investment to the rate of change in national income.

A rapid increase in income (and, consequently, consumer expenditure) will encourage firms to increase their existing production capacity, thereby encouraging new investment to meet the anticipated increase in AD in the future.

Consequently, this principle helps to explain why a modest increase in consumer spending typically results in a larger increase in the production of necessary capital equipment.

Illustration Consider a company that produces products with ten machines, each of which produces 1,000 units per year. Also, assume that the present annual demand for the firm’s output is 10,000 units.

If the demand increased to, say, 12,000 units, two additional machines would be ordered to produce the additional output. If demand subsequently increased to 15,000 units, three additional machines would be purchased, and so on.

Note that the 3,000 increase in demand represents a 25 percent increase in the output of products (from 12,000 to 15,000 units that year).

The procurement of an additional three machines increases machine manufacturing industry output by fifty percent (from two to three machines that year).

Therefore, the increase in consumer demand has accelerated the production of new devices.

But if consumer demand stopped growing, the company would cease investing, and a minor decline in consumer demand would precipitate a much larger proportional decline in machine demand.

## 5.5 Multiplier-Accelerator Principle and the Business Cycle

If an increase in actual demand (or even anticipated demand) exceeds existing capacity, firms will invest in additional capital equipment.

Since additional investment expenditure (I) is an injection, the multiplier effect will cause the level of national income (Y) to increase by more than the initial increase in investment.

The increase in national income may stimulate a further increase in planned consumer expenditure, which, through the accelerator process, leads to an increase in planned investment expenditure.

These interactions between multiplier and accelerator effects are the cause of economic activity peaks (booms) and valleys (recessions).

This session addressed the multiplier effect and its influence on national income equilibrium, as well as its significance in national income accounting. The accelerator principle and its implications for enterprises and national income were also discussed.

Hope you enjoyed the session.

## Self-Assessment Questions

Exercise 2.5

1. What is the multiplier effect? Illustrate with an example.
2. How does the multiplier effect influence business cycles?
3. Outline the importance of the national income multiplier
4. Explain the accelerator principle.
5. How different is the accelerator principle from the multiplier effect?
6. When do we say we have a demultiplier effect?

CONTINUE WITH SESSION:6 