Civil Engineering Reference
In-Depth Information
Demand Management
When a government is faced with a situation in which resources are unemployed
and the economy is generally running below full capacity, it can intervene in
various ways to reflate the economy. The easiest option is to increase its own
spending, and thereby inject funds into the circular flow. This idea, known as
demand management, was fashionable throughout Europe from 1945-1975. It was
an attractive option because injections of government funds were seen to have a
multiplier effect on national income level and employment.
THE MULTIPLIER THEORY
The theory of the
multiplier
builds on the circular flow concept - on the idea that
expenditure determines the level of output and its associated income. In other
words, when people are employed they spend their wages on goods and services
produced in other sectors of the economy which, in turn, generate employment and
spending elsewhere, creating an upward spiral. Keynes argued that if the current
amount of expenditure is insufficient to maintain full employment it becomes
advisable for the government to intervene - or, to express it in journalistic terms, to
'kick start' or 'pump prime' the economy.
Consider this scenario: assume a government invests £40 million for a new
road. This will cause expenditure and output to raise by the same amount. To
increase output, more labour will be taken on. New firms may be started. The
newly employed resources will be rewarded with incomes to the value of the initial
injection. However, as this money circulates around the economy, some of the
£40 million will leak out of the flow in the form of savings, imports or taxes.
Economists refer to this as the
marginal propensity to leak
(MPL). The concept of
the margin - as we discussed in
Chapter 7
- focuses on additional or incremental
amounts. The marginal propensity to leak, therefore, represents the proportion of
the 'additional' income that does not get used on consumption. If we assume an
MPL of 25 per cent, we can quickly calculate that households will spend £30 million
of their increased income on
consumer goods
. (Certainly if the recipients of income
injected by government spending were previously unemployed, we would expect
these households to spend any additional income coming their way on consumption
rather than saving.) This additional spending will add a further boost to total
expenditure. In turn, firms producing consumer goods will increase output, and they
will take on more resources and have to pay out more in interest, wages and rent in
order to earn more profit. Again incomes will increase. This will lead to successive
rounds of further expenditure. If we continue to calculate the increase in additional
expenditure occurring as a result of the initial additional government investment of
£40 million, we find that national income is 'pumped up' by a significantly larger
amount. In this example, it would actually be £160 million. The determining factor
is the size of the leakage, since the multiplier is equal to the reciprocal of the MPL.
In developed European economies the leakages are quite large and, accordingly, the
multiplier effect is significantly smaller than our example suggests.
