What this lesson teaches
I can explain how a change in AD has a multiplied effect on national income.
Syllabus 9570, 3.1.2(e). Aggregate Demand and Aggregate Supply: How changes in the components of AD can have a multiplied effect on national income
Make a guess
The government spends an extra $1 billion building MRT lines. By how much does national income eventually rise?
- By exactly $1 billion.
- By more than $1 billion.
- By less than $1 billion, because some of it is saved.
Show the answer
By more than $1 billion.
The first $1 billion becomes income for construction firms and workers, who spend part of it, and that spending becomes someone else's income.
An initial rise in spending raises national income by more, because one person's spending becomes another's income.
When spending on domestic output rises, the firms and workers who receive it earn more income. They spend part of it on other local goods, which becomes income for someone else, and so on.
So the final rise in national income is larger than the first rise in spending. This is the multiplier effect.
Each round is smaller than the last, because part of every extra dollar leaks out: into saving, taxes or imports.
Put these in order
A community venue spends $10,000 on local catering. Put the rounds of the multiplier in order.
- The rounds shrink until the total rise in income is well above $10,000.
- Shop owners and hawkers earn $4,000 more and spend part of it locally.
- The caterer's owners and workers earn $10,000 more.
- The venue pays a local caterer $10,000.
- They spend $4,000 at local shops and hawker centres.
Show the answer
- The venue pays a local caterer $10,000. The payment is income for the caterer's owners and workers.
- The caterer's owners and workers earn $10,000 more. They spend part of it locally; the rest leaks out into saving, taxes and imports.
- They spend $4,000 at local shops and hawker centres. That $4,000 is now income for the shop owners and hawkers.
- Shop owners and hawkers earn $4,000 more and spend part of it locally. Each round is smaller than the last, because part of every dollar leaks out.
- The rounds shrink until the total rise in income is well above $10,000.
The more that leaks out, the smaller the multiplier. In Singapore, a large share of extra income is spent on imports, and CPF contributions add to saving, so the multiplier is small.
- Multiplier
- Final change in income > initial change in spending.
- Leakages
- Saving, tax and imports shrink each round.
Worked example: A community venue's order
A community venue spends an extra $10,000 on local catering.
- Round 1: the caterer's owners and workers earn $10,000 more.
- Round 2: they spend part of it locally, say $4,000, at shops and hawker centres; the rest is saved, taxed or spent on imports.
- Round 3: those shops' workers spend part of their $4,000 locally, and so on.
- Total income rises by more than $10,000, but each round shrinks.
Watch out for this
The multiplier means every extra dollar of spending is spent again in full.
Only part of each extra dollar is spent on local output; the rest leaks out. That is why each round is smaller.
Check your understanding
Why is Singapore's multiplier relatively small?
- Government spending in Singapore is small, so it adds little to AD.
- Singapore's firms already work at full capacity, so output cannot rise.
- A large share of extra income is spent on imports and saved.
Show the answer
A large share of extra income is spent on imports and saved.
Right. High leakages mean each round of spending is small.