MULTIPLIERS
Let's suppose that the economy is in balance
and suddenly there is an increase in investment (for example,
a foreign investor makes a strong investment) or public expenditure
increases (for example, the Government decides to make a large
investment in roads). What then happens to the balanced production?
The money coming in increases, as
investment and public expenditure are components of aggregate
demand.
But as aggregate demand and the country's
income increases, consumption will also increase (people have
more money and they consume more) which means a new increase
in demand.
Therefore, a process begins which makes the final
balanced production greater than the initial increase that the
public expenditure experienced and which served to trigger this
process.
And the question that people ask themselves is,
when will the balanced production increase? To answer this question
we will look at how the multiplier works.
1. Investment Multiplier
The easiest way to see how it works is with an
example:
Let's suppose that the economy is in
balance and suddently there is an investment of 100.000 euros.
Let's also suppose that the propension marginal consumption
(MPC) is 0,6 (that's to say, if income increases by 1 euro,
people consume 0,6 euros and save 0,4 euros).
The investment of 100.000 euros means
an increase in the balanced production of this amount. This
is the first impact.
This increase in production (and therefore
in income) means that consumption will increase by 60.000 euros
(=100.000 * 0,6). This is the second impact.
But this increase in consumption makes
income increase again by 60.000 euros, which again means that
consmption increases by 36.000 euros (=60.000 * 0,6). This
is the third impact.
And so on.
If we add up the different impacts, we will see
how much the balanced production has increased. To see this we
will use the following formula:
Variation in balanced production
= (1 / (1 - MPC)) * Variation in investment
Applying this formula to the example, we can see
that by adding 100.000 euros to the investment means an increase
in the balanced production of 250.000 euros.
The coefficient (1 / (1 - MPC)) is called"multiplier
of investment" and measures how much income increases for
every euro which increases investment. This multiplier is always
greater than the unit.
The greater the marginal propensity
of consumption (MPC) greater the multiplier. To try it out,
you can repeat the previous example by introducing the MPC at
0,8 and again with 0,5.
2. Multiplier in public
expenditure
It works the same way as the investment multiplier:
the increase in production is greater than the increase in public
expenditure. The multiplier is:
(1 / (1 - MPC))
The multiplier (not only the investment
multiplier but also the public expenditure multiplier) is modified
if a tax exists that taxes income.
Let's look again at the previous example,
but this time suppose that a tax exists that taxes income at
20% (increase in investment of 100.000 euros and propension
marginal consumption at 0,6).
The investment of 100.000 euros produces
an increase of 100.00 euros in the balanced production. First
impact.
This increase in proudction means an
increase in income for the same amount (100.000 euros) but 20%
goes towards paying taxes, therefore the income avaialbe is
80.000 euros. This increase means an increase in consumption
of 48.000 euros (=80.000 * 0,6). Second impact.
This increase in consumption increases
income by 48.000 euros, of which 20% goes towards paying taxes,
being the new increase in the income available by 38.400 euros,
of which 23.040 euros will go towards consumption. Third
impact.
In this case the multiplier is defined:
(1 / (1 - MPC* (1 -
t)))
"t" is the tax rate
In this case the variation in the balanced production will be:
Variation of the balanced
production = (1 / (1 - MPC* (1 - t))) * Variation of the investment
