The circular flow and the multiplier
The multiplier
- An injection raises income by more than the first amount — the multiplier.
- New spending becomes someone's income, part of which is spent again, and so on.
$$\text{multiplier} = \frac{1}{1 - MPC}$$
- MPC = marginal propensity to consume (fraction of extra income spent). A bigger MPC (smaller leakages) gives a bigger multiplier.
Practice
If the marginal propensity to consume (MPC) is 0.8, what is the multiplier? (1 ÷ (1 − MPC))
Multiplier = 1 ÷ (1 − 0.8) = 1 ÷ 0.2 = 5.
Practice
A bigger MPC (smaller leakages) gives a:
More of each round's income is re-spent, so the multiplier is larger.
The accelerator & drivers
- the accelerator: investment depends on the rate of change of output — rising demand → investment jumps.
- consumption/saving depend on disposable income, wealth, interest rates and confidence.
- investment depends on interest rates, expected profit, technology and confidence.
Practice
The accelerator says investment depends on the:
When output rises quickly, firms need lots of new capital, so investment jumps (the accelerator).
You've got it
Key idea
- the multiplier = $\frac{1}{1 - MPC}$; a bigger MPC → a bigger multiplier
- the accelerator: investment depends on the rate of change of output
- consumption depends on disposable income, wealth, interest and confidence