A Level Economics Pass or Fail?

As thousands of teenagers receive their A level grades, I am sure many of them would be able to do a better job of sorting out the economy than our present chancellor, who’s qualifications for the job include a degree not in Economics or Maths - but History..

We hear now that half of the economists who strongly supported the George Osbourne’s deficit-reduction-austerity plans are now asking for a rethink and urging the Treasury to take advantage of low borrowing costs to boost spending on infrastructure projects. 

Unlike George Osborne (and David Cameron) economists can see that the evidence now points to the need for a change of course. They know that without growth we can't get the deficit down – George Osborne is already forecast to borrow £150bn more than planned.

Output is now lower than it was when the coalition was formed two years ago while the Bank of England believes it will take until 2014 for gross domestic product to return to the peak reached in early 2008. The economy is expected to contract by 0.2% this year.

Roger Bootle, managing director of Capital Economics, said: "If I were chancellor at this point, I would alter the plan, I would stop the cuts to public investment and I might even seek to increase it. Supply-side reform might be welcome but what we're talking about here is a shortage of demand. The key thing is to try and get the private sector to spend its money and that may require a bit of government spending to prime the pump."

What he is referring to in simple terms is ‘the multiplier effect’

The Multiplier Effect

Every time there is an injection of new demand into the economy there is likely to be a multiplier effect. This is because an injection of extra income leads to more spending, which creates more income, and so on. The multiplier effect refers to the increase in final income arising from any new injection of spending.

The size of the multiplier depends upon household’s marginal decisions to spend, called the marginal propensity to consume (MPC), or to save, called the marginal propensity to save (MPS).  This in turn is largely dependent upon economic confidence.

When income is spent, this spending becomes someone else’s income, and so on. Marginal propensities show the proportion of extra income allocated to particular activities, such as investment spending by UK firms, saving by households, and spending on imports from abroad. For example, if 80% of all new income in a given period of time is spent on UK products, the marginal propensity to consume would be 80/100, which is 0.8.

The following formula to calculate the multiplier uses marginal propensities, as follows:

1/(1-mpc)

So, if consumers spend 0.8 and save 0.2 of every £1 of extra income, the multiplier will be  

1/(1-0.8)

= 1/0.2

= 5

This means the multiplier is 5, which means that every £1 of new income generates £5 of extra income.

The multiplier concept can be used any situation where there is a new injection into an economy for example when the government funds building of a new motorway or invests in a home building programme, as has been suggested.

Of course, there is also the downward or ‘reverse’ multiplier..

A withdrawal of income from the circular flow (austerity cuts, reductions in public spending etc etc) will lead to a downward multiplier effect which will further lead to a reduction of spending and economic activity...

Or in other words, just what George has been doing for the last year.