Wednesday, December 24, 2008

How Does Negative Multiplier Effect Works Into Whole Economy?

Negative multiplier effect: An initial fall in AD which subsequently leads to a much larger fall in GDP

To see how damaging the effect towards the entire economy, let me illustrate with an example:

We begin with the ailing financial institutions. Due to the collapse or near collapse of many large firms such as Lehman Brothers, AIG, Citibank, Goldman Sachs, Freddie Mac & Fannie Mae, many had begun to restructure their operations. Among the most common measures taken are to retrench workers to minimise the operating costs, especially in the current climate of heavy losses

The first round of large scale unemployment had caused humongous drop in private consumption (C). Since C is a component of AD, therefore AD must necessarily fall. In reality, real GDP begins to slow down & inflationary pressure starting to ease. Since these people spend lesser on the High Street, businesses begin to see losses or fall in profitability. Since the demand for their goods or services fall, it makes no economic sense to maintain those workers who are now idling around in a quiet shop. Therefore this leads us to second round of retrenchment. Unemployment rate increases again. C further fall, economic growth rate is slowing down at a faster pace & price level shrinks again.

This creates fear even among those who still have a job. As such fear over job insecurities lead to their cut in spending. Unemployment is reported on the rise again next month & this is the third round of retrenchment. Does it stops here or just affect people or businesses in certain area?

Let’s look at how this spreads. Inability of bank to generate lending due to credit crunch also caused demand for housing to fall. As property market becomes gloomy, they will in return retrench their workers causing the same effect as mentioned above. As no one turns into buying house, this has a negative spill over effect to other related industries such as kitchen companies, furniture shops, lawyer firm, mortgage advisors etc. Therefore the effect is magnified through rising unemployment once again

Is that all? Wait. Difficulty in generating lending, had also caused large banks to turn down the appeal of GM, Chrysler & Ford to access funding to restructure their operation. It is well known that the Big 3 were not making much (even make quarterly losses) in the recent years due to the fast falling market share compared to Japanese car makers. If assistance is not given, their collapse will add about more than 1,000,000 workers to the unemployment statistic. Don’t forget, many industries are relying on car such as wind screen & gearbox manufacturers etc

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