The Multiplier Effect Of Money Within The Commonwealth’s Economy
When you go to the store with part of your paycheck and spend $10, the store operator may use a portion of that money to pay his rent. The land lord receiving the rent spends part of his income on gasoline. The service station operator also has expenses to meet such as payroll, utilities and the purchase of fuel stocks to replenish what he has sold.
Economist refer to this exchange of money and its circulation within the economy as the “multiplier effect.” The multiplier operates on the principle that one individual’s expenditure is another individual’s income. Eventually, money leaves the economy, often in the form of import purchases, vacations, gasoline and anything else purchased off island.
Each time money changes hands within the economy it is known as a “round.” At some point a portion of the money is no longer circulating on the island and is “fugitive.” The first round of expenditures might represent the actual expenses related to the cost of doing business. Round two estimates the subsequent distribution of these payments by the recipients of round one payments. For example, in the case of the various taxes paid to government, this factor has been estimated to be 0.5 which means that for every tax dollar paid to the government, fifty cents is returned directly into the economy in the form of wages and salaries, local purchases of supplies, etc. In-as-much as the government has been maintaining a deficit account balance, it follows that all revenue obtained by the government is expended for operations and capital improvements. It has been assumed that the remaining fifty cents paid to the government in taxes is available to meet government interest payments, expenses associated with direct off island purchases, etc. These funds are not in direct circulation within the economy and are not considered as having a multiplier effect. That brings us to the third round as government employees spend their income and as venders meet their expenses and cost of sales to the government and so on. Each level, or round, of expenditures induces further consumption although at a reduced level.
Because the Commonwealth is a consumer oriented society and almost all consumption items are imported, the multiplier effect of monetary flows is not as pronounced as in the case of other areas that have the ability to substitute imports with locally produced goods and services. Finally, one arrives at the fourth and weakest round of transfers within this economic model. For purposes of this representation we have elected not to go beyond a fourth round of currency flows to depict an ever diminishing impact which eventually results in all such funds being fugitive as they leave circulation within the island economy in the form of import purchases and other external payments. In examining the model it should also be appreciated that one can not carry the specific expense identity of a first round line item description, e. g., taxes, housing rental, etc., forward to the second and subsequent round of cash flows. This is because the money available for the second round is available for an entirely new series of expenses of which several might be student tuition, recreation, etc., and so on, none of may be related to the business operation generating the first and original round of cash flows. Any measure of the multiplier effect is nothing more than an elaborate combination of estimates based on a mathematical multiplier known as a “factor.” To the extent that the “factor” is in error then the calculation will be erroneous. However, hazardous as it is, such estimates are an improvement over the intuitive method which some would employ without any attempt to measure the elements involved. The technique can provide a measure of the value of a particular industry to the economy as well as to the government. The scenario has been developed based on various factored formulas which are believed to represent conservative estimates of the various rounds of currency transactions throughout the economy. It should be recognized that any measure of the multiplier effect consists of an intricate combination of mathematical factors representing induced expenditure activity within the economy with the factor at each level, or round, descending in value. To avoid being overly optimistic, and in maintaining a conservative approach, we have developed low, (conservative) factors to develop even those high estimates presented.
The development of conservative estimates of the multiplier factors largely negates the possibility of exaggerating the impact of the industry’s contribution to the economy. Appendix * The Size of the Multiplier The expenditure multiplier (M) equals 1 / (1-MPC) or M = 1 1 – MPC The higher the MPC means the larger the multiplier. Example: MPC Multiplier 9 /10 10 4 / 5 5 3 / 4 4 2 / 3 3 1 / 2 2 1 / 3 1.5 * Real World Significance of the Multiplier The multiplier explains why small changes in spending can induce much larger changes in output. The multiplier implies additional spending will bring idle resources into production, leading to additional real output rather than increased prices. * Limits on the Multiplier Leakages in the form of taxes and spending on imports will reduce the size of the multiplier.
It takes time for the multiplier to work. A lack of idle resources dampens the multiplier effect through an increase in the price level. Three Main Points * Changes in output, as well as changes in prices, play a role in the macroeconomic adjustment process, particularly in the short run. * The responsiveness of aggregate supply to changes in demand will be directly related to the availability of unemployed resources. * Fluctuations in aggregate demand are an important potential source of business instability.