However, with higher unemployment, the unemployed workers will also spend less leading to lower demand elsewhere in the economy. This will cause an initial fall in national income. If the government cut spending, some public sector workers may lose their jobs. The multiplier effect can also work in reverse. But, secondary effects lead to a further increase in AD (AD3) and an increase in real output (Y3) The initial increase in AD (aggregate demand) causes a rise in output to Y2. In this case, the multiplier effect is 1.33. Therefore the final increase in GDP is £4bn – from the initial injection of £3bn.This creates an additional economic output of £1bn.The suppliers also employ more workers – creating more employment. In the next period, workers spend part of this extra income – in shops and for transport.This involves employing workers (previously unemployed) and paying suppliers for raw materials. In this case, the government spend £3bn on building roads.It is also related industries and service industries who see some benefits.Įxample of multiplier effect from government investment In other words, if you increase salaries in the NHS, it isn’t just NHS workers who benefit from higher incomes.This will lead to another injection into the economy, causing higher Real GDP Therefore these workers will also increase their spending.Therefore firms would employ more workers and pay higher salaries. This extra spending would cause an increase in output.shopkeepers would earn money from increased sales. For example, if they spent 50% of the extra income there would be another £1 billion injected into the economy.However, with this extra income, workers will spend, at least part of it, in other areas of the economy.If the government spent an extra £3 billion on the NHS this would cause salaries/wage to increase by £3 billion therefore National Income will increase by £3 billion.In this example, the multiplier would be $100/$50 = 2.The fiscal multiplier effect occurs when an initial injection into the economy causes a bigger final increase in national income.įor example, if the government increased spending by £1 billion but this caused real GDP to increase by a total of £1.7 billion, then the multiplier would have a value of 1.7.Įxample of how the multiplier effect works Thus, the change in GDP is $800 – $700 = $100 billion. Suppose the equilibrium level of GDP is $700 billion. If government spending increases by $50 billion, GDP rises from is $700 billion (at Y 0) to Y 1 $800 billion (at Y 1). Since the change in GDP is greater change in AE, the multiplier is greater than one. The spending multiplier is defined as the ratio of the change in GDP ( ΔY) to the change in autonomous expenditure ( ΔAE). It should be clear that the increase in GDP from Y 0 to Y 1 is greater than the increase in expenditure from AE 0 to AE 1. The new equilibrium level of GDP occurs at Y 1. The vertical distance between the two AE lines is the increase in aggregate expenditure. This could be caused by an increase in autonomous consumption, investment, government spending or net exports. Consider an increase in AE to AE 1, which is shown by a parallel shift in the AE line. We can show the expenditure multiplier graphically using the income-expenditure model. The original level of aggregate expenditure is shown by the AE 0 line and yields an equilibrium level of GDP at Y 0. Showing the Spending Multiplier Graphically Using the Income-Expenditure Model
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