# A2 Economics – Multiplier

Just been looking at the multiplier with my A2 class and here are some notes and a mindmap. An initial change in AE can have a greater final impact on equilibrium national income. This is known as the multiplier effect and it comes about because injections of demand into the circular flow of income stimulate further rounds of spending.

Multiplier Process

Consider a \$300 million increase in business capital investment. This will set off a chain reaction of increases in expenditures. Firms who produce the capital goods that are ultimately purchased will experience an increase in their incomes. If they in turn, collectively spend about 3/5 of that additional income, then \$180m will be added to the incomes of others. At this point, total income has grown by (\$300m + (0.6 x \$300m). The sum will continue to increase as the producers of the additional goods and services realize an increase in their

incomes, of which they in turn spend 60% on even more goods and services. The increase in total income will then be (\$300m + (0.6 x \$300m) + (0.6 x \$180m). The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow.

The value of the multiplier can be found by the equation ­1 ÷ (1-MPC)

You can also use the following formula which represents a four sector economy

1 ÷ MPS+MRT+MPM

MPS = Marginal propensity to save

MRT = Marginal rate of tax

MPM = Marginal propensity to import

MPC = Marginal Propensity to Consume (of additional income how much of it spent)

e.g. \$1m initial spending; MPC=.8

=> income generated = 1/(1-.8) = 1/.2 = 5

=   \$5m

=> \$4m extra spending (\$1m initial, \$4m extra spending, \$5m total)

Use different equations depending on the information given.

e.g.: a) if the MPC is 0.5 – 50% of the income will be spent, 50% will be saved.

then MPS is 0.5 then the multiplier is 2 = 1/0.5 = 2

b) if the MPC is 0.8 – 80% of the income will be spent then MPS is 0.2 then the multiplier is 1/0.2 = 5

c) if the MPC is 0.9 – 90% of the income will be spent then MPS is 0.1 then the multiplier is 1/0.1 = 10

What is the effect of MPT – the marginal propensity to tax or t.

• greater MPT would lead to less income being spent in the economy

Below is a very informative mind map that I copied from an old textbook.

# China’s ghost cities – there needs to be another plan

Below is a very good report from 60 Minutes Australia that gives you an update on China’s ghost cities. Roughly 22 percent of China’s urban housing stock is unoccupied, according to Professor Gan Li, who runs the main nationwide study. That adds up to more than 50 million empty homes, he said. One solution that the government could use is property or vacancy taxes to try to counter the issue, but neither appears imminent and some researchers, including Gan, say what actually counts as vacant could be tricky to determine.

For so long China has relied on major infrastructure projects including building cities to drive growth figures in their economy. Historically China’s economic model was based on export-led growth, massive government injections into the economy and access to cheap money. This is not sustainable and although you can keep blowing up bridges and build cities that nobody lives in at some point it becomes unsustainable. Furthermore since the global financial crisis economies have increased protectionist policies to look after their own economy and this has been followed with by the potential trade war with the USA. Therefore the Chinese government need to refocus the growth of the economy on domestic consumption rather than building things – Gross Fixed Capital Formation. So much more C than I in the GDP Expenditure equation. EG:

GDP = C↑+ I↓+ G + (X-M)

# New Zealand election: economic impact of new Government’s policies.

Since the election businesses seem to be unsure of the new direction of government policy and therefore this has led to a reduction in business confidence. This is not unusual especially with a change of political ideology and the more left leaning government which could make things – regulation, taxes etc – harder for businesses. The government plans to cancel next year’s scheduled tax cuts even though it would have added 0.4% to GDP. This could be partly offset by an increase in expenditure on Working For Families and the free tertiary education for first year students.

The new Government plans to spend more than the national government which is not unusual considering its position of the political spectrum – see graph. This will be partly funded by tax revenue and borrowing \$7bn more over the next four years – this is a borrowing and spend fiscal stimulus. The impact of this spending will be influenced by the fiscal multiplier.

Fiscal Multiplier.
It refers to the change in GDP that is due to a change in government fiscal policy – taxes and spending. For example, if increased government spending of \$1bn causes overall GDP to rise by \$1.5bn, the multiplier effect is 1.5.

There are problems for the new Government in that:

1. Some of this extra spending will go on imports and this will mean an outflow of money from the New Zealand economy and therefore making no contribution to GDP. Remember that GDP expenditure approach = C+I+G+(X-M).

2. There is also the crowding out effect – this is when government spending fails to increase overall aggregate demand because higher government spending causes an equivalent fall in private sector spending and investment. This could include: extra spending on public healthcare leading to less spending on private healthcare; government employment creating labour shortages for firms; and government employment creating labour shortages for firms. Crowding out can also happen indirectly via fiscal stimulus increasing interest rates and consequently the exchange rate making exports less competitive and imports cheaper.

Ultimately the government debt must be repaid by the use of government revenue from taxation. A labour coalition government usually increase taxes during their time in government and this has the tendency to discourage private sector investment. The government’s borrow-and-spend plans will not necessarily make the economy any larger in the long-run but it is expected that government spending (G) will be a larger share of the economy with consumption (C) and investment (I) having a lower share – see graph below. Interesting to note the government spending as a % of GDP for Labour and National – goes up as a % of GDP when Labour are in office and goes down as a % of GDP when National are in office.

Source: Westpac Quarterly Economic Overview – November 2017

# Are higher wages the answer to the US economy?

There have been some concerns over the extent of the recovery of the US economy over the last year. The GDP of a country is made up of four things:
C+I+G+(X-M).

C = Private Consumption
G = Government Demand
(X-M) = Net Exports

With government spending being very liberal and effective in creating growth there is a need for the other components of GDP to do their part – Private Consumption, Business Investment and Net Exports.

Exports in the US have been disappointing equaling 14% of GDP compared to the euro zone’s 26%.

Business investment has also been subdued as lower profits mean less investment.

Private consumption hasn’t been as strong as anticipated even with the windfall gain of the significant fall in oil price and the growth of outstanding consumer credit. The biggest barrier to increasing private consumption is the level of pay to employees. Across the US median inflation-adjusted wages are not higher today than they were pre GFC.

Why are wages so low?
The Economist identified three things that have been behind the slow growth of wages in the US.

1. America’s Unemployment-Insurance

With the US government cutting back on unemployment benefits the wage expectations of workers fell. Businesses took advantage of this cheaper pool of labour and in 2014 a significant proportion of the 31 million jobs created wherein poorly paid industries.

2. The Behaviour of Firms
When the GFC hit firms found it difficult to reduce the wages of their staff but fired their least productive workers keeping the most productive happy. To compensate for the higher wages paid to the most productive firms were willing to offer new recruits only low wages.

3. Persistent Labour Market Slack

As there are worker available to fill jobs that become available firms are able to offer paltry wages. The number of part-time workers who would rather be full timers – called part-time for economic reasons (PTER) – fell much more slowly than the official unemployment rate following the GFC. The same can be said for discouraged workers i.e. the number of those wanting a job but say there is no point in looking. Research has found that a 1% fall in the PTER rate is associated with 0.4% fall in real wage growth. When the PTER is high, workers may feel unable to ask for higher wages, since what they really want is more hours.

It seems that the US economy lives and dies by what happens to consumer spending.

# Aussie still relying on consumer sector

The graph from National Australia Bank below shows the components of Australian GDP March Quarter 2014. This is particularly useful when doing GDP Expenditure approach in Unit 5 of the A2 Cambridge course where you can breakdown the equation C+I+G+(X-M).

C = Private Consumption
G = Government Demand
(X-M) = Net Exports

Consumption is still the largest contributor to Australia’s GDP. Over the next couple of years GDP  is expected to grow around 3% but key to meeting that target is a solid consumer sector. Household consumption growth in recent quarters has been solid, contributing 0.3 percentage points to growth in Q1 – only exports have contributed more to growth over the past year. However sustaining solid consumption growth in years ahead requires the labour market to improve and consumer confidence levels to recover from their recent lows.

# Aussie GDP – from Consumption to Net Exports

Below is an interesting look at the components of GDP in Australia. Capital intensive and net exports are the mainstay of growth this year. However it wasn’t always like this and notice the changes in consumption that reflect the GFC and the role of net exports in the recovery. Remember the equation:

# Consumers to Prosumers

In the March edition of the University of Otago publication EcoNZ@Otago there was a good article on ‘Prosumers’.

In markets, firms produce goods and services and consumers buy them (see Figure 1). This is the underlying set-up embodied in many economic models. Most of the time, the buyer-seller dichotomy is an accurate representation of market activity. Since the early 1990s, however, another paradigm has emerged. The advent of the internet has allowed some industries to assign a stronger role in the production of goods and services to those who purchase them (see Figure 2). Consumers are becoming prosumers and firms are benefiting (immensely) by consumer-led marketing and design.

A key feature of prosumers is that they are not paid for the work that they do. Every time you post a review about a product online, for example, you are either doing marketing for the firm (in the case of good reviews) or providing them with information about their product’s shortcomings which they can use to improve their wares (i.e. quality control, in the case of bad reviews). The firm pays you nothing for this. In some cases, prosumers work for the firm without even knowing it. Some websites monitor the buying activities of other users so they can suggest products to you based on the goods in your shopping cart. By simply buying online, you help the firm cross-sell products to others in the future.

But there is an even stronger role in the production process for prosumers! Occasionally, prosumers will take it upon themselves to build products from scratch and share them with other prosumers (see Figure 3). One example of this is the production of open-source software. In the 1980s, such software was made available under General Public Licensing (also known as copylefting), a licensing procedure developed by the Free Software Foundation. Anyone is allowed to use and modify copylefted software under the conditions that: (1) they do not attempt to impose licensing restrictions on others, and (2) all enhancements to the code are licensed on the same terms.This means that any programmer who makes alterations to the code can claim ‘bragging rights’ for their work, but they cannot charge others to use it.

# Oil Shocks – are they bad for the global economy?

Tobias Rasmusses and Agustin Roitman, two IMF economists, in a recent paper have argued that oil shocks are not that bad for an importing country. They have suggested that a 25% increase in oil prices will cause a loss of real GDP in oil-importing countries of less than 0.5%, spread over two to three years.
“One likely explanation for this relatively modest impact is that part of the greater revenue accruing to oil exporters will be recycled in the form of imports or other international flows, thus contributing to keep-up demand in oil-importing economies”
However in considering the impact of higher oil prices one must look at what caused them to rise in the first place. There have been supply-side and demand-side reasons.

1973 – 400%↑ – supply-side– Yom Kippur War oil embargo
1979 – 200%↑ – supply-side – Iran Iraq War
1990 – 50%↑ – supply-side – Iraq War
2000 – 75%↑ – demand-side – Global growth.

What it is important to remember is that when there is higher global growth there likely to be higher oil prices, which is a positive. Supply-side policies also play a role – 1970’s and 1990-91 – especially the disruption to supply in Libya this year. “Finding that the negative impact of higher oil prices has generally been quite small does not mean that the effect can be ignored.”
Rasmusses and Roitman do not rule out more adverse effects from a future shock that is driven largely by lower oil supply than the more demand-driven increases in oil prices that have been the norm in the last two decades.