The Multiplier and National Income

The Multiplier

• The presentation introduces the concept of the multiplier in macroeconomics, covering its meaning, how to measure the overall level of business activity, and related issues.

National Income

• Finding the overall level of business activity requires the income and expenditure functions.
• These functions involve the withdrawals and injections functions.

Circular Flow of Income

• A diagram illustrates the circular flow of income between firms and households, which includes factor payments, consumption, injections, and withdrawals.
• Injections include government spending (G), Investment (1) and exports (X).
• Withdrawals include savings (S), taxes (T) and imports (M)

Income Function

• Total earnings are allocated to domestic goods and services, or savings.
• The income function is represented as Y = Cd + W, where Y is income, Cd is domestic consumption, and W is withdrawals.
• The income function is represented by a 45-degree line.
• Withdrawals or leakages from the economy include:
  • S: Net savings (saving - borrowing/drawing)
  • T: Net taxes (taxes - benefits)
  • M: Import expenditure

The 45-degree Line

• At a 45-degree angle, earnings are entirely spent on domestic consumption or withdrawals.
• This line starts at the origin and has a slope of 1, meaning for every increase in income, there's an equal increase in expenditure or withdrawals.

Expenditure Function

• The expenditure function includes the following components:
  • E = C + I + G + X - M
  • E = (C - M) + (I + G + X)
  • E = Cd + J
• J represents injections, which are independent of income and thus exogenous.
• J is horizontal on a graph.
• Injections into the economy include money spent by firms on plant, equipment, building up stock of inputs (I), excluding money spent on imported components.
• Government spending on infrastructure like roads, hospitals, and schools (G), but excludes state benefits.
• Export expenditure (X) excluds parts of exports imported from other countries

Consumption Function

• The Consumption function is represented as Cd = a + bY
  • a stands for automous consumption
  • b stands for income-induced consumption
• Here, a is the intercept, representing autonomous consumption, which is consumption independent of income.
• The slope b represents income-induced consumption, showing how consumption changes as income changes; b also represents the marginal propensity to consume.
• The slope b, the marginal propensity to consume, typically falls between 0 and 1.

Movements along the Consumption Function

• Different combinations of consumption and income cause movement along the consumption function.
• Movements represents how much consumption changes as income changes, under ceteris paribus conditions.

Shifts in Consumption Function

• Relaxing the "ceteris paribus" assumption leads to shifts in the consumption function due to changes in consumer confidence, wealth, interest rates, tax rates, ease of credit, and the environment.
• Random shocks like health pandemics also cause shifts.
• Shifts in the consumption function were observed during 2020 and 2021, concurrent with GDP growth changes in the United Kingdom.

Equilibrium National Output

• The equilibrium national output is where Y = Cd + W and E = Cd + J
• Cd represents the consumption function, shown as an upward-sloping curve with a slope between 0 and 1.
• At equilibrium, withdrawals equal injections (W=J).
• Comparative statics assess the effect of changes in government spending, investment, interest rates, etc., on the equilibrium output and macroeconomic variables.

The Multiplier

• Comparing the change in injections (J) with the change in equilibrium income (Ye) measures the multiplier effect.
• The change in J, denoted as ∆J, is equal to the change in government spending, ∆G.
• The change in Ye (∆Ye) is larger than ∆G because of the multiplier effect.
• The multiplier effect occurs because initial spending becomes someone else's income, which is then spent and becomes further income.

How the Multiplier Works

• If a country with a marginal propensity to consume of 0.8 receives a £100 increase in income then:
  • Individuals will spend £80
  • The other individuals will receive £80 and spend £64
  • Individuals who receive £64 will spend £51.20 and so on
• The final effect on national output is £100 + £80 + £64 + £51.20 + ... which totals about £500.
• The change in spending becomes smaller each time.
• The multiplier effect is calculated as ∆ΥΕ/ΔΕ, which equals £500/£100 = 5 in this example.
• The multiplier is also equal to 1/(1-mpc) = 1/0.2 = 5.
• Since an extra income of £1 can either be consumed domestically or withdrawn, 1 = 0.8 + 0.2 = mpc + mpw
• The formula to calculate the multiplier effect is 1/(1-mpc) = 1/mpw.

Issues with the Multiplier

• Estimating the multiplier effect involves estimating the marginal propensity to withdraw or consume.
• Issues include how long individuals will spend their extra income, how much will individuals actually spend, and what the average marginal propensity to consume is.
• This information is crucial for macroeconomic stability.
• An accurate estimate of the multiplier is crucial because if it's too low, the economy may get stuck. If it's too high, there might be a potential risk of overinflating the economy.

The London Olympics

• The London 2012 Olympic and Paralympic Games had a multiplier effect of £5 Billion.
• There were 78,000 additional jobs in the construction industry between 2005 and 2017.
• 61,000 additional jobs were in the tourism industry, contributing £2 Billion to GDP.
• There were concerns that London took most of the benefits at the expense of other regions in the UK.

Macroeconomic Factors

• Key macroeconomic considerations are unemployment, inflation, and exchange rates.

Unemployment

• Unemployment refers to individuals who do not have work but are looking for work at a given wage rate.
• Claimant unemployment is the measure of all those in receipt of unemployment benefits.
• Standardized unemployment includes people of working age, without work, available to start within two weeks, actively seeking employment or waiting to take up an appointment, per quarterly national labor force surveys.
• Claimant unemployment may be higher or lower than standardized unemployment.
  • Standardised unemployment may include people seeking work who are not entitled to claim benefits
  • Claimant unemployment may include those who are claiming benefits but not actively seeking work

Causes of Unemployment

• There are 2 types of unemployment, equilibrium and disequilibrium.
• Equilibrium unemployment is when the labor market is in equilibrium:
  • Frictional unemployment or search unemployment occurs when individuals move between jobs.
  • Structural unemployment occurs when individuals lose their jobs as the industry they work in declines.
• Equilibrium unemployment allows individuals to move from one job to another and respond to changes in market conditions; it’s sometimes called "voluntary unemployment".

Disequilibrium causes of unemployment

• Disequilibrium employment is when the labor market is not in equilibrium.
• Real-wage unemployment results when the actual real wage is above the wage that clears the labor market.
• Demand-deficient unemployment occurs when there is a lack of demand for labor in an economy; known as "involuntary unemployment."

The Labour Market (Supply and Demand for Workers)

• The vertical access is given by the average wage rate, while the horizontal represents the number of workers.
• The aggregate supply of labor (AS) is upward sloping because more individuals are willing to work as wage increases.
• The aggregate demand for labor (AD) is downward sloping because firms are less willing to employ workers as wage rates increase.
• The point where AS and AD meet represent the equilibrium wage (We) and equilibrium number or workers (Le).

Equilibrium Unemployment

• N is total labor force of all who are part of the work force.
• AS constitutes the individuals willing to supply their labour at a given wage rate.
• At a given wage rate there may be people in the work force but are not willing to supply their labor, this is called equilibrium unemployment

Equilibrium unemployment factors

• At the equilibrium wage (We) there is some equilibirum unemployment
• As wage increases more individuals are willing to work, including those not previously.
• Examples of equilibrium unemployment include frictional unemployment (search), structural unemployment, and even seasonal unemployment.

Disequilibrium Unemployment

• Disequilibrium unemployment occurs where labour supply exceeds labour demand.
• "Sticky" wage rates cause wages not to fall immediately to equilibrium.
• Factors include real wage unemployment, demand-deficient unemployment, and cyclical unemployment.

Effects of Labour Demand Shifts

• A random event like a pandemic will decrease demand for labor.
• Under this circumstance, the aggregated-demand will shift from AD to AD' and create a new equilibrium
• If some employees are not willing to accept lower wage, a portion of the population will become unemployed.

What happens to the work force if labour shifts

• Even if there is a decrease in demand, some people may not be prepared to accept lower wages.
• This can result in both disequilibrium and equilibrium unemployment in the economy.

Causes of Inflation

• A sustained rise in the general price level is caused by rising oil and import prices, including increased money supply.
• Demand pull-inflation and cost-push inflation are factors as well.

Analysis of Causes of Inflation

• Aggregate demand and aggregate supply models determine the equilibrium based on equilibrium levels of domestic output.

Demand-Pull Inflation

• This occurs when increased aggregate demand raises prices.
• Economic growth can cause the aggregate demand curve to shift the right, creating inflationary pressure.

How do firms respond to increased demand

• Many firms either expand production or increase the price of goods, or a balance of both.
• If the economy is at full capacity, increasing prices becomes the only avenue
• This can cause conflict toward lowering employment versus higher wages.

Cost-Push Inflation

• Firms respond to cost of production increasing by charging a higher price in order to maintain profits.
• How much can firms increase their prices depends on the elasticity of demand

Results of costs increases

• Increased prices for customers will result in a decrease in overall demand.
• The national output also decreases alongside rise and inflation and unemployment.

Interaction between demand-pull inflation and cost-push inflation

• Government interventions via increased expenditures or subsidies can impact levels of employment or inflation.

Government controls

• Governments must carefully balance unemployment versus inflation because addressing one issue could impact the other.
• Implementing technological progress or education programs could address both issues.

Costs of Unemployment and Inflation

• Unemployment:
  • includes personal and financial costs
  • lower output and profit for firms
  • and lower overall tax revenue
• Inflation:
  • erodes the value of investments, particularly when interest rate is low
  • creates uncertainty within costs and revenues that can be difficult to predict

The Effects of a Financial Crisis

• The financial crisis can be triggered via supply-side shocks, as well as demand-side.
• The financial crisis depresses aggregate demand and, at the same time, increases the cost of production, leading to lower output and higher price levels.

Government response to a financial crisis

• Depending on which levers the government attempts to use, there could be benefits and detractors.
• Interventions from government and/or central bank may not always be effective and have counter-acting variables to consider.

Business cycles

• Business cycles in one country may "coordinate" cycles with other countries because of trade.

Financial Crisis and Contagion

• Because of the interdependance between countries, getting out of a recession is much more difficult especially if most countries have one.

Impacts on Businesses

• Cost of production increase due to high oil prices
• Some businesses cut out the middle man in the processing of materials in the distribution chain which may impact different businesses

Exchange Rates

• The presentation introduces concepts related to exchange rates, including their determination and the effects of currency depreciation.

Exchange Rate Determination

• Considers a floating exchange rate where the price of one currency is determined by supply and demand.
• The rate is the price of £ in $Qf is the quantity of £
• $/£ is the price of £
• D is demand for the £ in the US; influenced by US residents, and lower price for £ increases demand.

Supply

• S is the supply of £ by the UK; influenced by those in the UK. Higher dollar price means they will trade for more pounds.

Equilibrium

• The intersection of supply and demand determine the equilibrium exchange rate, i.e. $/£"*
• In the case supply would outstrip demand, there would be a market depreciation
• Demand outstripping supply will lead to appreciation