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The multiplier effect comprises the multiple effects that an initial change in the aggregate demand can have on the level of equilibrium national income of an economy. The multiplier effects are a result of injections into the aggregate demand of an economy. The injections include investment and government expenditure. The government expenditure multiplier estimates the impact that the unit change in the level of government expenditure of a country can have on the final output level in the economy. This total change in the output level or the total aggregate demand because of a unit change in the government expenditure level is the government expenditure multiplier (Kuroki, 2012).
Multiplier Concept According to Keynes
According to Keynes, the multiplier concept is one of the means of achieving full employment in an economy. This approach to management of demand helps in overcoming the shortage of business capital investment, which is a function of the level of government expenditure required to produce national income level that ensures enough job availability in the economy. The government expenditure multiplier is a function of the marginal propensity to consume and the marginal propensity to tax. An elevated marginal propensity to consume implies that the small change in the government expenditure level will lead to large proportionate change in the national income level. One way of affecting the government expenditure multiplier is by adjusting the marginal propensity to tax. Reduction in tax propensities will add to the amount of income available for spending among consumers, which has a direct effect on the amount of the government expenditure multiplier. The marginal propensity to tax is the other element that influences the size of the marginal propensity to import. The Keynesian model also requires that the aggregate supply in an economy should be elastic in order for the national income level to respond to changes in the level of injections. In the event, that the aggregate supply is inelastic, changes in the aggregate demand due to injections will be inflationary, leading to price increase, instead of raising the national output of the economy (Kuroki, 2012).
The Multiplier Process and How the Government Expenditure Multiplier Works
Consider the following example:
Assuming that if consumers get one extra dollar as income, they tend to consume 80% and save 20% of it. This implies that the marginal propensity to consume is 0.8, and the marginal propensity to save is 0.2. The marginal propensity to save and the marginal propensity to consume always must add up to 1.
Suppose that the government wants to increase its spending by 10 billion dollars. Assume also that the marginal propensity to consume is 0.8, and that of saving is 0.2. Initially, the government will spend the entire 10 billion dollars, which, consequently, will increase the value of national output by 10 billion dollars. At this point, the $10 billion is in the hands of consumers, who have a propensity to consume of 0.8. According to Keynes, the consumers will spend 80% of the additional income that have acquired as a result of the government injection. Thus, the total GDP of the country will increase by $8 billion. After these two transactions, the GDP of the country will increase by a total of $18 billion, which is a summation of the first government injection of $10 billion, and the consumption expenditure of $8 billion by consumers. The recipients of the $8 billion also have an MPC of 0.8. Thus, they will spend 80% of $8 billion, which is $6.4 billion. At this point, the total increase in the national output because of the $10 billion government injection will be the total of the three figures.
GDP growth = 10+8+6.4=$24.4 billion
This process continues as the money injected in the economy by the government circulates among consumers.
Keynes came up with a simple multiplier that can estimate the total impact of a government injection on the level of national output.
Government expenditure multiplier= 1/ Marginal propensity to save
Thus, in the above illustration, the government expenditure multiplier will be 5.
Marginal Propensity to Save= 0.2
Multiplier = 1/0.2=5
Thus, the total increase in the GDP level will be 5*10=50 billion dollars.
Assumptions of the Multiplier
The government expenditure multiplier has a tendency of ignoring some of the foreign economic effects, which are vital for countries that have highly established trade sectors. For example, an increase in the government expenditure for a country such as the US is likely to lead to an increase in the national income of another economy, which may increase the level of exports of the US. Such a situation may have additional effects on the multiplier effect.
The government expenditure multiplier assumes that an increase in the level of government expenditure will lead to an increase in the real output level. However, for this assumption to apply, the economy must have the spare capacity to accommodate the increase in the aggregate demand element. This means that the economy must not be at full employment for the government expenditure multiplier to be effective. The aggregate supply function of an economy must be elastic. In such a manner, it will allow the economy to be responsive to any change in the level of government expenditure. If this provision does not hold, any additional increase in government expenditures will increase the price levels of goods and services, which is inflationary. The other assumption is that the interest rates in the economy are always remaining constant. In case, of an increase in the aggregate demand due to injections, the central monetary unit takes necessary steps by raising the interest rates.