The negative multiplier effect occurs when an initial withdrawal of spending from the economy leads to knock-on effects and a bigger final fall in real GDP.
For example, if the government cut spending by £10bn, this would cause a fall in aggregate demand of £10bn. However, the effect may be greater than the £10bn. If nurses lose their jobs, then they will spend less money, causing lower demand for shopkeepers and cafes. Also, if the government are buying few capital goods, then factories will see a fall in demand.
Causes of negative multiplier effect
It could be a decrease in injections.
Fall in consumer spending
Fall in investment
Fall in exports
Fall in government spending.
Or it could be an increase in withdrawals from the circular flow. It could include:
Tax – reducing disposable income
Imports – spending flows abroad
Save – household income saved rather than spent.
Coronavirus and negative multiplier effect
The spread of the Coronavirus is causing many negative economic effects.
A decline in travel – leading to falling revenue for airlines and travel companies.
A decline in trade and firms running out of spare parts
A fall in confidence causing a decrease in travel and a decrease in investment.
These effects all cause a fall in demand and lower economic growth. However, they can be exacerbated by a negative multiplier effect which affects people not directly linked to the virus.
For example, airline companies may have to lay off staff. People working at Heathrow or for airline company lose their jobs and therefore there will a fall in consumer spending in these areas. Leading to further falls in demand elsewhere in the economy. If there is a fall in global trade, all firms connected to trade and travel will see a fall in demand.
What determines the size of the negative multiplier effect?
The value of the multiplier depends upon the percentage of money loss that would have been spent (marginal propensity to consume MPC). For example, if there are higher taxes on the wealthy, this tax represents a withdrawal from the economy. However, the fall in spending may be quite low because the wealthy have a low marginal propensity to save.
Life-cycle models. It is possible that if people see a temporary fall in income, e.g. higher tax, they may dip into their savings to maintain spending and this limits any negative multiplier effect.
Withdrawals may cause injections. In the first example, we saw how a fall in government spending may cause a fall in aggregate demand and a negative multiplier effect, but in practice, a fall in government spending may enable an increase in the private sector spending (crowding in). Lower spending enables lower tax or lower borrowing – both of which enable more spending.
What stops the negative multiplier effect?
The negative multiplier effect suggests that a fall in spending causes a negative spiral but in practice, we don’t see a permanent decline. Economies can bounce back and the negative multiplier effect is limited.
People dip into savings to maintain income.
Inventories fall. In a recession, firms may run down stocks, but after a while, they need to restock creating new orders.
Not all business will fail at the same time. In a recession, there may be increased demand for inferior goods/ normal goods, which maintains demand.
Welfare state. Unemployed received benefits from the government to maintain spending
Injection from abroad. One economy may experience a slump, but then see demand rise from abroad.
Withdrawals countered by new injections. Higher tax is a withdrawal from the circular flow and may cause a fall in demand. But, with higher tax, the government may spend more on investment.
Monetary policy. In response to falling demand, monetary authorities may cut interest rates to make borrowing cheaper and boost demand.
The rational thinker