Advanced Macroeconomic Theories: Multiplier and Accelerator

The Multiplier Effect

• Definition: A process by which changes in aggregate demand (AD) components lead to greater changes in national output.
• Diagram: Increase in AD shifts the aggregate demand curve to the right (Y1 to Y2), causing an initial growth in national output.
• Further Impact: The multiplier effect suggests that this growth will continue beyond Y2 due to subsequent rounds of spending.

How the Multiplier Works

• Initial increase in AD → Creates more income → Leads to further spending → Cyclical process.
• Ultimately leads to a much greater change in national output than the initial increase in spending.

Measuring the Multiplier

• Equation: Multiplier = 1 / (1 - Marginal Propensity to Consume (MPC))
• MPC: Proportion of additional income that is spent.
  • Range: 0 to 1 (1 means all additional income is spent, 0 means none is spent).

Marginal Propensity to Withdraw

• Alternative measure: 1 / (Marginal Propensity to Withdraw (MPW))
  • MPW = Marginal Propensity to Save (MPS) + Marginal Propensity to Tax (MPT) + Marginal Propensity to Import (MPI)
  • Represents proportion of income not spent.

Example Calculation

• Government injects £100 million into the economy
• Assume MPC = 0.8 → Multiplier = 1 / 0.2 = 5
• Final change in GDP = Multiplier * Initial Spending = 5 * £100 million = £500 million

Diagram Explanation

• Initial AD curve (AD1) at price level P1 and output level Y1
• Government spending shifts AD to AD2 (Y1 + £100 million)
• Multiplier effect further shifts AD to final output (Y1 + £500 million)

Factors Determining the Multiplier Size

• MPC: Larger MPC → Larger Multiplier; Smaller MPC → Smaller Multiplier
• Factors Affecting MPC:
  • High savings culture → Lower MPC → Smaller Multiplier
  • High taxation → Lower MPC → Smaller Multiplier
  • High import spending → Lower MPC → Smaller Multiplier

The Accelerator Effect

• Focus: Investment spending (not consumer spending)
• Concept: Investment changes are directly linked to changes in the rate of GDP growth
• Mechanism:
  • Increasing GDP growth rate → Increased firm investment
  • Decreasing or negative GDP growth rate → Decreased firm investment

Impact on Business Cycle

• Both effects (Multiplier and Accelerator) help to explain the shape of the business cycle.

Summary

• Multiplier: Concerns consumer spending and leads to cyclical increases in output
• Accelerator: Concerns investment spending and is linked to the rate of change in GDP growth
• Both concepts are crucial for understanding fluctuations in economic activity.