Multiplier Effect

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Marginal Propensities

Different marginal propensities are important for working out how big the multiplier effect in an economy.

Marginal propensity to consume (MPC)

The marginal propensity to consume (MPC) is calculated as the change in C divided by change in income.
The MPC represents the amount of each extra pound that the consumer spends when given an extra pound in income.
If the MPC was 0.25, this means that for each extra pound in income, they spend £0.25.
People who earn less money or live in poorer countries usually have higher MPCs.

Marginal propensity to save (MPS)

The marginal propensity to save (MPS) is calculated as the change in savings divided by change in income.
The MPS represents the amount of each extra pound that the consumer saves when given an extra pound in income.

Marginal propensity to tax (MPT)

The marginal propensity to tax (MPT) is the change in tax paid divided by the change in income.
The MPT represents the amount of each extra pound earned that is spent paying taxes.
The MPT can also be called the marginal tax rate.

Marginal propensity to import (MPM)

The marginal propensity to import (MPM) is the change in imports purchased divided by the change in income.
For every extra £1 of income, the MPM is the proportion of that £1 spent on imported goods.

Multiplier Effect

The multiplier is defined as an initial change in an injection or leakage that leads to a much greater final change in real national income. One person’s consumption is another person’s income.

How the multiplier works

Let's say a government decides to build a new hospital at a cost of £50 billion.
Government spending (G) will rise by £50bn. AD and real GDP will rise by £50bn.
The government will spend £25bn of this money on a construction firm. The firm spends £10bn on investment (I), a component of AD. Investment rises by £10bn.

How the multiplier works cont.

The firm also spends £5bn on workers who receive higher incomes and spend this – so now consumer spending (C) goes up by £5bn. C is another component of AD.
AD has risen £65bn (£50bn plus £10bn plus £5bn) from an initial £50bn.
So, if spending rises by an initial £50bn, there will be one large rightwards shift in AD. But each stage of the multiplier effect could be viewed to add another small rightwards shift in AD, each of a smaller size than the last.

Marginal propensity to consume

The marginal propensity to consume (MPC) is calculated as change in C divided by change in income.
The MPC represents the amount of each extra pound that the consumer spends when given an extra pound in income.
If the MPC was 0.25, this means that for each extra pound in income, they spend £0.25.
The higher the MPC, the higher the multiplier – it means more money is passed on at each “stage”.
So if taxes rise, then more money is leaked. So the MPC must fall, and the multiplier falls.

Calculating the multiplier

Because some money will be leaked, eventually less and less is passed on. So if we add up all the stages, we can come up with a total increase.
To calculate this, we can use the following formula:
- Multiplier = $\frac{1}{(1 - MPC)}$
- E.g. If MPC = 0.2:
- Multiplier = $\frac{1}{(1 - 0.2)}$
- Multiplier = $\frac{1}{0.8}$ = 1.25
An initial injection of £10bn will result in £12.5bn increase in real national income.

The Multiplier Effect visually

Marginal propensity to consume in real life

Japelli (1990) found that 20% of the American population was credit-constrained.
Gross & Souleles (2002) found that 2/3 of people responded to automatic increases in their credit card limits by spending more.
Both these studies suggest that the MPC may be high and that the availability of credit (or debt) could be the constraining factor.

Marginal Propensity to Withdraw

The marginal propensity to withdraw = MPS + MPT + MPM. Savings, taxes, and imports from abroad are all 'withdrawals' from the economy. Extra earnings are either spent consuming goods or are withdrawn. MPC + MPW = 1. So the Multiplier effect also equals 1/MPW.

Marginal propensity to withdraw

The marginal propensity to withdraw is the proportion of additional earnings that are taken out of the economy via savings, taxes paid to the government or imports from abroad.
The marginal propensity to withdraw = MPS + MPT + MPM.

Marginal propensity to save

The MPS is the portion of extra income that is saved by an individual.
Savings are a withdrawal and cannot be spent on consumption.
A higher MPS will increase the MPW and reduce the size of the multiplier in the economy.

Marginal propensity to tax

The MPT is the portion of extra income that is spent by an individual paying taxes to the government.
Taxes are a withdrawal and cannot be spent on consumption.
A higher MPT will increase the MPW and reduce the size of the multiplier in the economy.

Marginal propensity to import

The MPM is the portion of extra income that is spent by an individual paying for imports from overseas.
Imports are a withdrawal and cannot be spent on consumption.
A higher MPM will increase the MPW and reduce the size of the multiplier in the economy.