Concept of the Multiplier Essay

Excerpt from Essay :


Thailand, like many third world countries, is interested in identifying the mechanisms by which economic growth may be achieved. Economic growth and more specifically 'rapid economic growth falls within the province of the mid-term and long-term macroeconomic policies (Dervis and Petri 1987, p. 211). Dervis and Petri, survey 20 'middle income' countries, in an attempt to identify the factors which contribute to successful development-which they identify as moderately rapid economic growth as measured by changes in the GDP ((Dervis and Petri 1987, p. 213-214). The work Dervis and Petri is over 20 years old; it is useful only to set a baseline for the macroeconomic challenges faced by developing countries, in comparison to the macroeconomic challenges faced by Thailand in 2011 and beyond.

Primary indicators of success in included among others, three factors. First, political stability- the authors note that often many developing countries experience a period of rapid economic growth only to suddenly experience a crisis which singularly reverses years of growth and expansion (Dervis and Petri 1987, p. 214-216). Second, high-investment, countries that experienced consistently elevated levels of investment outperformed countries where capital was not secure and capital flight began to occur. (Dervis and Petri 1987, p. 213). Finally, the authors also noted that, developing nations with aggressive borrowing strategies had GDP growth which was sustained at levels above those developing nations which eschewed taking loans from the developed nations (Dervis et al. 1987, p. 218).

It is imperative to see if any of these strategies pursued 20 years ago have any implications for what Thailand's current macroeconomic strategy should include and the role that the concept of the multiplier effect may play.

Thai Government

Bhanupong explores the decision by the Thai Government in the aftermath of the financial crisis to determine to what extent the decisions have been effective in alleviating the downturn in the export economy. In the wake of the 2008 world financial crisis the fiscal centers of the many of the world's nations were directly and negatively impacted. Thailand, however, managed to weather storm differently although not without some negative impact. Thailand's interaction with the crisis occurred primarily in Asian nation's export economy (Bhanupong 2010, p. 121). Fortunately, the Thai banking and financial sectors had few investments in the type of sub-prime debt which precipitated the crash. In the first year after the crisis data for Thailand show a 15% decrease in the amount of exports. Id. More importantly, political instability and low consumer confidence have severely altered Thailand's upward economic growth trajectory; as early as 2006, Thailand was experiencing decreases in "consumer consumption and investment." Remember that in Dervis and Petri, the data suggested that economic growth sustained by sound economic policy and a favorable business environment, could be wiped out by political instability. The reduction in Thailand's export sector can be attributed directly to the overall decrease in the "world trade volume" (Bhanupong 2010, p. 122). The Thai economy, unlike many other countries, is overly dependent on the purchasing power of foreign nations, and therefore is often more sensitive to downturns in world trade which result directly in decreases in the Thai export sector.

Bhanupong addresses and explores the effect of the monetary policy which the Thai Central Bank has embraced. Of critical importance to the macroeconomic concept of the multiplier, is the central bank's decision to lower interest rates and to intervene in the baht/dollar exchange rate- this is related to monetary policy- and the accompanying Thai Government's fiscal policy to expedite and increase public spending (Bhanupong 2010, p. 130). Although Bhanupong's article does not directly address the role of the multiplier, the author's observation provides us with two recommendations. These recommendations will suggest how a thorough understanding of the concept of the multiplier effect would aid the Thai Government's management of its macroeconomic environment. Namely, a thorough understanding of the concept of the multiplier effect would illuminate the long-term effects of domestic spending, the decrease in interest rates, and the management of the Baht's exchange rate. It is hoped that such an understanding of the role of the multiplier will suggest new and complementary strategies to accompany the existing monetary and fiscal policy.

Multiplier Introduction

The multiplier effect, as it pertains to the Thai government, has two formulations. In the first instance we are concerned about the multiplier effect as a money multiplier. More generally we are also concerned about the multiplier effect as it pertains to fiscal policy in the form of the fiscal multiplier.

The multiplier effect, a cornerstone of Keynesian economics, is generally concerned with the effect on a nation's GDP or output for every additional unit of currency spent-usually by the government (Claes-Henric 1977, pp. 242-245). This concept allows us to approximate to what extent changes in the interest rates and the fiscal contributions of the government will have on the money supply or on aggregate output (Sommers HM 1949, pp. 269). The former is known as the concept of the money multiplier and the latter is referred to as the fiscal multiplier (Id).

Good fiscal policy seeks multipliers greater than 1. For instance, for every Bhat spent by the Thai government, ideally the increase in the Thai GDP may be 1 or 1.5 such that for each Bhat spent by the government there is an increase in consumption or investment which equals 1 or more Bhats. On the other hand, a multiplier less than 1 suggests that the expenditure of the government has had a negative effect on GDP; this negative effect of the Bhat spent by the government does not activate the public sector in consuming or exporting more (Id).

For our purposes when the multiplier effect is discussed with respect to Thailand we are concerned with the money multiplier. This equation, in its most common formulation, is rendered as: Multiplier= 1/(1-MPC) (Mankiw 2006). MPC- is the marginal propensity to consume. When a Bhat is passed through the economy each subsequent consumer is assumed to save part of the Bhat and spend the rest. MPC is the amount of the Bhat Thai citizens spend after saving. This rate can vary year to year based on a nation's savings rate. Additionally, since at each stage the amount of Bhat is decreased since each consumer before you has saved some, you subtract the MPC from 1, which is further divided by a factor of 1 to give you the money multiplier in given economy (Mankiw 2006).

For our specific analysis we are interested in the money multiplier as it pertains to the Thai central bank. In this instance we are concerned about changes to the money supply in the nation which originate in decisions by central banks regarding the increase or decrease in banking reserves. The increase of banking reserves by a single Bhat will be multiplied in the overall banking system as a multiple of the increase (Chipman, 1949, pp. 178-179). Where M= the changes in the money supply, R=the percentage of deposits which must be held in reserves by a bank subtracted from the excess reserves-this is determined by central banks, and m= the multiplier percentage in a given nation (Miyazawa, 1960, pp. 53-62).

The lesson for the Thai central bank is 1) the effect of a single retraction or insertion of a Bhat into the Thai economy will be multiplied throughout, and 2) that the ability of a of the government to engineer macroeconomic growth by harnessing the government spending and applying the multiplier effect will be diluted if the central bank fails to manage inflation. In other words, when the government spends and consumes-when done properly this may spur economic growth- the ultimate effect of government consumption may be nullified inflation. Managing inflation is the domain of central banks across the world.

Intimately related to the concept of the multiplier effect is what the multiplier equation allows us to identify -- namely what is the real change in the GDP. The GDP equation is commonly rendered as Y=C+I+G+(X-M). Where Y= Gross Domestic Product (the sum total of all of the goods and services produced by a nation within a year), C= Consumption (this variable is used to calculate all of the new goods and services which have been consumed the previous year; I= investments ( this represents monetary expenditures on current production but where the consumption is postponed until the future; G= government expenditure (this includes both government expenditures such as on wages and goods an d their investment on infrastructure etc.; and finally X=Exports and I = Imports: the total gain from international trade requires that the value of a nation's goods be subtracted from a nation's imports. In verbal terms, the expenditure approach to GDP calculation is simply the amount of consumer consumption added to government expenditures and investment plus the difference of a nation's exports minus its imports (Mankiw 2006).

Multiplier Effect Recommendations

Contemporary economic theory suggests that when it comes to the impact of domestic spending on long-term economic growth, governments should focus on capital…

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