Download Evaluate using the multiplier, the likely effect on the UK price level

Evaluate using the multiplier, the likely effect on the UK price
level an equilibrium real output of the changes referred to in
the information provided.
The multiplier effect is where a change in autonomous expenditure will lead to an even
greater change in income. As figure 1 show, average UK national debt as a multiple of
average income has increased over the past few years. Additionally figure 2 shows that
the average UK household interest payments as a percentage of average income have
actually decreased over past years. Therefore it can be assumed that consumers have
been spending increasingly more, and consumption (largest component of AD) has
increased year upon year, resulting in a prominent rightward shift in AD.
When considering the multiplier effect, we can expect further successive shifts, as
the increased consumption circulates around the economy. This will keep on pushing
the AD curve to the right by smaller and smaller increments, consequently the price
level and real output will go up. The UK economy during this period appears to be
experiencing strong growth; a boom hence moving towards the inelastic part of the
Keynesian LRAS curve. Therefore a large right-ward shift in AD curve will result in a
larger increase in the price level and a smaller increase in GDP. This problem is
intensified when considering the multiplier effect. Successive shifts in AD to the right
will mean the price level will increase significantly compared to GDP. Inflation will be
high, thus higher wages will be demanded, and the cost of production will increase.
The LRAS curve will shift to the left, further increasing the price level, but now
decreasing real output; this cost push inflation will have an adverse effect, trapping
the UK economy in a vicious cycle.
This however, depends on the magnitude of the multiplier; in reality it may only be 1 or
2. Also, withdrawals in the economy must also be taken into account. As people
purchase more, they will spend more money on imports and holidays and this will
reduce how much consumption increases by and therefore AD will shift. Therefore the
price level may only rise slightly more than the increase in real output.
Extract 1 explains that interest rates should be raised to combat the perturbing
levels of debt accumulated by British households, and increase the amount paid
back by the British household. Increased interest rates will mean borrowing money
will become more expensive and saving money will become more attractive.
Therefore both consumption and investment will decrease. Both these determinants
are the largest components of AD therefore the demultiplier will potentially be very
large. Divestment and decreased consumption will mean the AD curve will shift
greatly to the left and carry on doing so due to demultiplying effects; because its
demand deficit and consumer demand decreased and prices will fall and then it
becomes less profitable to produce goods/services. Output will then fall, therefore
the output curve will also shift to the left. The demultiplier effect will result in both
the price level and GDP falling from P1 to P2 and Y1 to Y2.
However the AS curve will shift to the left as output falls, and therefore GDP will fall
again but now the price level will increase due to cost-push inflation. Nonetheless, the
amount that the AD curve will shift depends upon the effect of a rise in interest rates
will have on exports. A rise in interest rates should result in an appreciation of
Sterling. Therefore the UK will begin to export more and import less and this will
minimise the amount that AD shifts. This however, is likely to be insignificant as
exports are only a small component of aggregate demand in the UK economy.
Extract 2 states that the UK could see growth in exports due to greater trade with
newly expanding countries in Asia. Exports are injections so a positive multiplier effect
will be observed, and in the short-run this will shift the AD curve to the right. The
price level will rise in addition to a rise in GDP. Yet, when considering the classical
LRAS curve may shift to the right in AD this can be devastating to the UK economy due
to the perfectly inelastic nature of the curve, the price level will keep on rising without
seeing a rise in GDP. This will result in a rise in inflation.
If UK exports were to rise considerably then this would make it a greater
component of AD. Greater exports will be an injection into the economy. This will
mean due to the multiplier that AD will keep on shifting to the right. Also, the trade
deficit will be reduced. UK firms will see more demand, and it will become more
profitable to export and therefore output will increase.
The AS curve will shift to the right which is good as GDP will rise but the price level will
fall. However, this all depends upon the fact that the UK can take advantage of the
increased growth in other countries. Competition is high, and the UK will find it hard to
compete with other countries such as China due to wages being higher and increased
regulation, all of which increase the costs of production. The UK therefore may struggle
to export more especially if interest rates rise and investment decreases.