Chapter 4 Applied Extension Exercise – The Keynesian multiplier
- Examples of AD factors that can raise economic activity:
- Increased disposable income
- Increased consumer or business confidence
- Lower interest rates
- A depreciation of the currency
- Higher rates of economic growth in major trading partners’ economies.
- If any of the AD factors result in an increase in AD, this should have a positive impact on production levels in the country and employment. If for example, consumer confidence were to increase, then households may be more willing to spend a larger portion of their disposable income (their MPC will increase). This creates an extra source of demand for consumer goods and services. The producers of the goods/services will notice and increase in sales and will seek to increase their production levels. To do so may require more labour resources, which will help to reduce the unemployment rate. The profits of the businesses should increase (a source of income) and a greater number of workers will be earning a factor income (further increasing income).
- When the new workers are employed, their income may increase above the level they were paid when they were unemployed. They will have more income, which they can spend on other goods and services. This creates a second round of demand and as a result the producers of those products will seek to increase production. This may further promote growth in employment and further stimulates growth in income.
- If there is an economic downturn, the unemployment rate is likely to rise. This creates a market situation where there is a surplus of labour. A fully flexible labour market would allow the ages to fall that would help to boost the demand for labour and reduce the unemployment problem. With stick wages, the market cannot return to its equilibrium so Keynes argued that government needed to provide the incentive for demand to increase again (this would be unlikely to happen when there was low employment rates and an associated fall in confidence). By intervening in the market direct (through government spending), this increases AD and this generates further income growth and employment.
- If the MPC increases, the impact of a $1 increase on spending will be greater. This means that there will be less leakages coming from the economy and this further helps to boost economic activity. As a result, the multiplier tends to be larger when the MPC is greater because for each round discussed in question 3, the amount that gets re-spent in the economy is high.