1. AS Macro Revision
Multiplier, Accelerator Effects and
Keynesian Economics
Spring 2014

2. We add new resources / links / articles every day
to our Economics blogs
Follow this link for the AS Macro Blog on Tutor2u
www.tutor2u.net/blog/index.php/economics/categories/C59

3. The Multiplier Effect
A change in one of the components of aggregate demand (AD) can
lead to a multiplied final change in the equilibrium level of GDP
1. The multiplier effect comes about because injections of
new demand for goods and services into the circular flow
of income stimulate further rounds of spending – in other
words “one person’s spending is another’s income”
2. This leads to a bigger final effect on national output and
total employment
The formal calculation for the value of the multiplier is:
Multiplier = 1 / (sum of the propensity to save + tax + import)

4. An Example of the Multiplier Effect
The government injects £200m
in a project to build thousands
of new affordable houses
Why is the final increase in
measured GDP likely to be more
than £200m?
If the final rise in GDP is £300m the value of the multiplier = 1.5
If the final rise in GDP is £250m the value of the multiplier = 1.25

5. The Multiplier Effect Process
If asked to do so, explain the process that lies behind the multiplier
effect – focusing on the extra demand and incomes created
A new-build housing project injects £200m of
new demand and output into the economy
Many businesses benefit directly including
building supply industries, architects etc
The government injects
£200m in a project to build
thousands of affordable
new houses
Building new houses generates a new flow of
factor incomes – including wages and profits
Will the extra income stay inside the circular
flow of income and spending?
If so, the multiplier effect is likely to be strong

6. Marginal Rate of Leakage and the Multiplier Value
The rate of leakage from the circular flow
Assume that for each £100 of extra income
• 10% is saved
• 20% is taken in taxation
• 20% leaks from the economy in imports
Multiplier = 1 / (sum of the propensity
to save + tax + import)
If propensity to save = 0.1
Propensity to tax = 0.2
Propensity to import = 0.2
Then the multiplier = 1/0.5 = 2
At each stage the extra money flowing
around the circular flow gets smaller
• £20m saved
• £40m taxed
• £40m imports
£200m
Injection
£100m extra
GDP
• £10m saved
• £20m taxed
• £20 imports
• £10m saved
• £20m taxed
• £20m imports
£50m extra
GDP

7. Elasticity of Aggregate Supply & the Multiplier Effect
When AS is highly elastic,
multiplier effect likely to be high
When AS in inelastic, hard for
AS to expand to meet rising AD
GPL
GPL
AS
GPL1
AS
GPL1
AD2
AD1
Y1
Y2
AD2
Y
AD1
Y1 Y1
Y

8. Summary of Factors Affecting Value of the Multiplier
High Multiplier
Value
Economy has
plenty of spare
capacity
Low Multiplier
Value
Economy is
close to it’s
capacity limits
Propensity to
import and tax
is low
Rising demand
causes rising
inflation
High propensity
to consume any
extra income
Higher inflation
causes rising
interest rates
The Size of the Fiscal
Multiplier
Government
investment—things like
infrastructure building—
results in higher
multipliers.
Economists at the IMF
have calculated the longrun multiplier value at
1.5 for developed
countries and 1.6 for
developing countries.
Source: The Economist

9. We add new resources / links / articles every day
to our Economics blogs
Follow this link for the AS Macro Blog on Tutor2u
www.tutor2u.net/blog/index.php/economics/categories/C59

10. The Accelerator Effect
Where planned capital investment is linked positively to the past
and expected growth of consumer demand or national income
• Consider an industry where demand is rising quickly
• Firms will respond by making using their existing productive
capacity or running down stocks of finished products
• If they expect high demand will be sustained – they will
increase spending on plant and machinery, factories and new
technology in order to increase their supply capacity
• This causes an accelerator effect – where a given change in
demand for consumer goods and services will cause a
greater percentage change in demand for capital goods

11. Examples of the Accelerator Effect in action
The Negative
Accelerator Effect
Investment to create
extra capacity in cloud
storage
Investment in 4G
mobile networks
Expanding fleet sizes
of growing airlines
Capital investment in
renewable energy
When the rate of
growth of demand in an
industry slows then net
investment spending by
businesses often falls.
E.g. Declining
investment in steel
plants in a recession or
a drop in investment
demand when subsidies
for renewables are cut

12. Get help on the AS
macroeconomics course
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13. Key Keynesian Ideas
An understanding of Keynesian ideas can be helpful in evaluating
macroeconomic stability in terms of prices, jobs and incomes
• Keynesians believe that free markets
are volatile and not self correcting
• The free-market system is prone to
periods of recession & depression
• The volatility of aggregate demand
(AD = C+I+G+X-M) can be explained by
changes in consumer and business
sentiment – known as animal spirits
• In a world of stagnation or depression
direct intervention in the economy
may be essential
John Maynard Keynes was
born in 1883. He was
educated at Eton College
and at Cambridge
University - where he later
taught. He died in 1946

14. The Importance of Animal Spirits
John Maynard Keynes coined the notion of animal spirits which
refers to the driving force that gets people going in the economy
• Animal spirits refers to a mix of confidence, trust, mood and
expectations and animal spirits can fluctuate very quickly as
populations of people change their thinking
• When animal spirits are poor, individuals save more, businesses
save more too and, because demand and profits are lower than
expected, they cut back on production and perhaps postpone or
cancel capital investment projects.
• Higher saving and reduced investment both have the effect of
reducing demand and incomes in the circular flow causing an
economic contraction – this is called the “paradox of thrift”!

15. The Keynesian Liquidity Trap
A liquidity trap occurs when low interest rates and a high amount of
cash balances in the economy fail to stimulate aggregate demand
• In normal circumstances it is possible to boost demand by cutting
interest rates. But there is a zero floor for nominal interest rates
• Even if interest rates can be lowered this may have little effect if
people cannot or will not borrow. This is known as the liquidity trap.
• At this point, AD can only be boosted by the Government borrowing
more, either to spend directly or to give to others via tax cuts
• Keynesians believe that size of the fiscal multiplier effect is higher for
government spending than it is for tax cuts
• When private sector demand for goods and services is low, the
government needs to find a compensating source of demand to
rebalance the economy – and the solution comes from the
government in the form of higher borrowing or less saving

16. Keynesian Approaches to Managing Demand
Keynesian economists tend to favour the active use of fiscal policy
as the may way of managing demand and economic activity
Active measures
needed to inject
extra demand can
drag the economy
out of a recession
Keynesians favour
labour-intensive
projects e.g.
Transport
infrastructure and
new housing
Counter
cyclical
policies
Government
capital
spending
Targeted tax
changes
Tax cuts for lower
income groups
with higher
propensity to
spend boosts AD
Government
borrowing
can pay for
itself
Depending on the
size of the fiscal
multiplier –
borrowing will
create more tax
revenues

17. Get help on the AS
macroeconomics course
using twitter
#econ2
@tutor2u_econ
www.tutor2u.net