Discuss the significance of the multiplier in influencing macroeconomic policy decisions to achieve economic growth.

Introduction

Macroeconomic policy decisions are made by governments for the purpose of achieving specific macroeconomic goals, namely full employment, price stability, high and sustained economic growth, exchange rate stability, and a healthy balance of payments (BOP). These decisions  can be affected by the size of the multiplier as well as other factors such as the price elasticities of demand for imports and exports, as well as the extent of crowding out which can vary between countries, which can in turn affect the effectiveness of various policy tools to achieve growth.

Significance of the multiplier

The Keynesian multiplier, k, is a measure of the magnitude of change in national income (Y) given a change in autonomous expenditure, e.g. investment (I). The multiplier is shown by the formula k =1/ (MPM + MPS + MPT)

in which mps (marginal propensity to save), mpt (marginal propensity to tax) and mpm (marginal propensity to import) represent three marginal leakages that may be present in a four sector economy. For every additional rise in income, a certain proportion is saved by the households, the government also takes a certain proportion away in the form of taxation and some is spent on imports. This additional income is taken away from the income flow.

Significant

Fiscal Policy (Expansionary)

Discretionary fiscal policy is the deliberate attempt by the government to change tax rates or the level of government expenditure in order to influence the level of aggregate demand. Expansionary fiscal policy (involves the government raising expenditure and/or reducing taxes) can be used to stimulate growth.

For example, the government spends on infrastructure projects such as building new expressways, this becomes an injection into the circular flow of income. Also, the government may try to stimulate consumption and investment by reducing tax rates. Reduction in income tax would stimulate consumer spending through an increase in personal disposable income, whereas reductions in indirect taxation and corporate tax would enable a given disposable income to buy more goods and services for consumers; and to raise after- tax profits and thus encouraged private investment for producers, which are injections into the circular flow of income. This will in turn lead to an increase in AD and subsequently, real GDP by a multiple.

In the case of a small and open economy such as Singapore, which is highly import dependent, the size of the multiplier is small (about 0.45) because of the high mpm, since much of the increases in injection leaks out of the economy as imports. Due to policies such as the government imposed CPF (compulsory savings) scheme as well as the tendency of Asians to save a high proportion of their income, the mps in Singapore is also high. Hence, an increase in, say, government spending may not have a significant impact on income and employment. Therefore, the effectiveness of fiscal policy is limited. Thus multiplier could be significant in influencing the policies (such as fiscal policy) used to achieve growth in countries like Singapore.

*Although Singapore still uses Fiscal Policy due to the supply side effect.

Not Significant Supply Side Policies

Supply side policies focus on an increase in productive capacity. They aim to increase the quantity and improve the quality of resources (CELL) as well as achieve technological advancement. These policies can help reduce cost pressures in the long run and at the same time, attain economic growth

Supply-side policies can be broadly classified into 2 categories: Interventionist Policies & Market-oriented Policies

Government intervention to encourage more research and development in specific fields will lead to an increase in the efficiency of production processes and also improvement in the quality of products.

(For example, biotechnology, maritime, aerospace or support industries that are considered beneficial to the Singapore’s economy are given more tax incentives or R&D support.)

The essence of these policies was to encourage and reward individual enterprise and initiative, to put more reliance on market forces and competition and less reliance on government intervention and regulation. Pro-competition policy is essentially a microeconomic policy. Increased competition encourages firms to improve their efficiency so as to lower average cost. Households will thus gain from more competitive pricing and product enhancement. The domestic economy also gains from more foreign investment and greater variety of imports. Supply side policies focus on an increase in productive capacity and would shift the LRAS rightwards from LRAS1 to LRAS2, as shown in Figure 1. This raise the level of real output from Y1 to Y2.

Supply side policies works through increasing AS and does not affect AE directly hence the policy is not directly affected by the multiplier effect. Thus Multiplier, in this case, is not significant in influencing the use of supply side policy to achieve growth

Other factors

However, there are other factors such as nature of economy, confidence level of consumers and investors as well as the budget position of the government that can influence the policy decision.

Price elasticities of demand for imports and exports

Price elasticities of demand for imports and exports refer to the extent to which quantity demanded for imports and exports will vary given a change in their prices. It varies depending on factors such as the number and closeness of substitutes available, as well as the import dependence of a country.

Through devaluation (exchange rate policy), a government hopes that export revenue can be increased through a lowering of exports’ prices (in terms of foreign currency) while imports can be reduced through increasing the imports’ price (in terms of local currency), thus discouraging import expenditure. With a rise in export revenue and a fall in import expenditure, balance of trade will improve and in turn, stimulate growth.

Nature of economy

Singapore is a price taker in world markets because it is too small to influence world prices. Producers in Singapore have to accept prices dictated by global demand and supply conditions. In addition, because of Singapore’s role as an international financial centre, the Singapore economy is very open to capital flows. As a result, small changes in the difference between domestic and foreign interest rates would lead to large and quick movements of capital. This makes it difficult to target money supply in Singapore thus we are unable to execute our monetary policy effectively to achieve our aims. Thus it is unlikely that Singapore is going to monetary policy to achieve economic growth.

Significance of crowding out

The crowding-out effect refers to a decrease in private expenditure (consumption and investment) that occurs as a consequence of increased government spending such as in the case of an expansionary fiscal policy, or interventionist supply side policies (e.g. subsidizing training or R&D) or in the financing needs of a budget deficit.

Crowding out effect may affect a government in the choice of ways through which it finances the policies mentioned above. To finance its large spending, some governments may turn to borrowing from individuals and firms. If funds in the market run low as a result, it will have to offer higher interest rates to obtain them and in so doing it will be competing with the private sector. This will force the private sector too to offer higher interest rates. With higher interest rates in the market, individuals and firms may be discouraged from buying on credit, hence causing C and I to fall. Thus government borrowing “crowds out” private borrowing. In the extreme case, the fall in consumption and investment may completely offset the rise in government expenditure; with the result that AD does not rise at all, hence defeating the purpose of the expansionary policy to raise income. Crowding out effect could be significant to countries such as US in policy decision due to their budget deficit/huge debts.

*May not be significant to countries like Singapore due to years of surplus

Confidence level

Confidence of the consumers and investment will also affect the extent in which C and I increase resulting from the use of the policies. Low confidence may result in a much less significant change in C and I given a change in say, interest rate. For example, when the economy is facing a recession with low consumer and business confidence, lowering interest rate may not have much impact on consumption and investment. If consumers are not confident about their future and are worried about possibility of retrenchment,  then increase  in consumption is minimal.Thus this will limit the use of certain policies to achieve economic growth.

*Other factors such as MEI, Liquidity trap or budget position etc could also be used.

Evaluation and Conclusion

In conclusion, multiplier is certainly significant in influencing the use of expansionary policies such as monetary and fiscal policies to achieve economic growth as it determines the total amount of expenditure generated in an economy when components of AD is increased. However, the multiplier does not impact the effect of supply side policies or other policies that increase potential growth.

In addition, multiplier is just one of the factors that influence policy decisions to achieve growth. The economy needs to consider the importance of other factors such as the condition and characteristics of the economy and the degree of crowding-out effect when making policy decisions too.

Leave a Comment

Your email address will not be published. Required fields are marked *