Macroeconomics and Tourism
Lecture 6

The Keynesian Multiplier Effect

1. Keynesian Multiplier Effect - the impact on the economy (or GDP) when spending or investment changes in the economy

• Example - Hilton builds a new resort-hotel on Langkawi
  • Direct Effect - Hilton invested $50 million in building the facility
    • Hilton hires 200 workers
    • Construction hires 500 workers (temporary)
  • Indirect Effect - with more income, the employees and construction workers spend more
    • New houses
    • New cars
    • Clothing, restaurants, cinemas, etc.
  • Induced Effect - local businesses have more customers and earn more profits and income
    • These businesses hire more workers
    • Workers work longer
    • These employees have higher income and increase their spending and savings
  • The process continues indefinitely
• The $50 million investment in Langkawi could result in more than $50 million in incomes
• Other benefits
  • More local labor is hired
  • More income generates more government's tax revenue
  • Government can increase its spending and provide more services to the community
• The more money changes hands, the higher the income
• Note - a tourist who bring foreign currency, will have the same impact

2. The multipler effect can also apply to a contraction

• Economists do not focus on this
• Example - a large firm or plant shuts down
  • Workers are laid off
  • They have less income and decrease their spending and savings
  • Other businesses experience a slow down
  • They reduce their workforce
• The process continues indefinitely
• Note
  • Less income means government collects less tax revenue
  • Usually government increases or expands taxes
• Example
  • Flint, MI - GM shut down its factories
  • Gary, IN - U.S. steel industry severely contracted with competition from Japan during 1980s
  • Problems
    • Jobs left, then the workers with money left
    • The poor were left behind, and crime and drugs became rampant

3. The ratio method to derive the multiplier

• What drives the multiplier?
  • Investment
  • Changes in government spending,and taxes
  • Changes in net exports
  • Tourists' spending
• Example: Investment increases by $100
  • MPC = 0.9 and MPS = 0.1
  • Round 1: Income increases by $100;    Savings is $10 and consumption is $90
  • Round 2: Income increases by $90      Savings is $9 and consumption is $81
  • Round 3: Income increases by $81      Savings is $8.10 and consumption is $72.90

• Infinity     Total savings is $100 and total consumption is $1,000
• This is an infinite sequence

• For our example, GDP changes by

• Note - Savers deposit their money into banks
  • The banks grant loans to businesses for new investment
  • If people hide their money in a mattress, then banks do not have money to lend out for new investment
  • Banks and investment go hand in hand with economic development
• We can also calculate the multiplier in two ways
  • First way we know MPS (or MPC), then the multiplier is:

• Second, if we knew how GDP changed when investment changed, then we use algebra to rearrange the equation to get:

Deriving the Multiplier

1. Definitions

• Disposable Income (DI) - remaining income after taxes are deducted
  • Disposable income is either spent on consumption or saved
• Marginal Propensity to Consume (MPC) - the amount a society increases its consumption, if its aggregate disposable income increases by $1
• Marginal is important!
  • Example, a low-income country has a GDP per capita of $5,000 per year
    • People may have low savings rate
    • People may have high consumption rate, because of food
    • Banking system may not develop well with low savings rate
  • Example, a high-income country like Qatar has a GDP per capita of $80,000 per year
    • People have high savings rates
    • Qatar can invest its money in developed countries like Europe and United States
  • Savings and consumption can be different for different levels of disposable income
• MPC is the slope of the consumption function, C = f(DI)

• Marginal Propensity to Save (MPS) - the amount a society increases its savings, if its aggregate disposable income increases by $1
• MPS is the slope of the savings function, S = g(DI)

• By definition, MPS + MPC = 1, because if disposable income increases, a society either spends it or saves it.
• As disposable income increases, both the consumption and savings increase
• Both C = f(DI), and S = g(dI) have positive slopes

2. Factors shift the consumption and savings functions

1. Wealth - households' level of wealth determines consumption and savings
   • As households become wealthier, their consumption may increase
     • physical - houses, cars, real estate, and land
     • financial - cash, stocks, bonds, pensions, etc.
   • Example - Financial crisis of 2008
     • Stock prices and home values are dropping, people become less wealthy and may decrease their consumption
     • Both consumption and savings functions decrease and shift downward.
2. Expectations - households expectations of the future determine consumption and savings levels
   • Example - A person graduated from college and found a high-paying job, his consumption and savings will both increase
   • 2008 Financial Crisis
     • With an uncertain financial future, households will save more
     • Consumption function could decrease and savings function could increase
3. Real Interest Rates - impact household consumption and savings
   • If real interest rates are low, households decrease their savings, and increase their consumption
4. Household Debt - households can borrow from future income
   • Households can consume more today by borrowing and increasing their debt
   • Consumption increases, while savings functions both could decrease
5. Taxes
   • If government increases taxes, disposable income decreases
   • Households have to lower their consumption and/or savings
   • Consumption and savings functions both could decrease

3. Aggregate Expenditures (AE) - the total spending by all sectors in an economy

1. Consumption
   • Autonomous Spending (A) - the y-intercept
     • Spending is independent of income (i.e. GDP)
     • Consumers still need a level of spending with no income
       • Food
       • Shelter, etc.
   • MPC - the slope of the line
     • Give consumers $1 more dollar in income, MPC is the amount that goes to spending

• A graph of the consumption is below:

2. Gross investment (Ig) - all investment in society
   • assume investment is independent of GDP and Aggregate Expenditures

• Net exports (Xn) = Exports (X) - Imports (M)
  • If Xn > 0, country exports more than what it imports
    • Expands domestic production
    • Has multiplier effect
  • If Xn < 0, country imports more that what it exports
    • Expands production for foreign country
    • Negative multiplier effect
    • The foreign country gets the multiplier effect
  • Shifting level of net exports
    • Prosperity abroad
  • Tariffs
  • Exchange Rates
• Government spending (G)
  • Independent of GDP
  • Government finances spending through taxes
    • Lump sum taxes - taxes are assessed as a fixed dollar amount

4. Equilibrium

• Equilibrium is when, Aggregate Expenditures (AE) = GDP
  • AE is one definition of GDP
  • This is the 45 ⁰line
• Leakages - withdrawals from income / expenditure stream
  • Savings
  • Taxes
  • Imports
• Injections - income is injected into income / expenditure stream
  • Investment
  • Government spending
  • Exports
• Equilibrium
  • AE = GDP and AE = C + Ig + G +Xn
  • Leakages = Injection s
    • S + T + M = Ig + G + X

5. Derive the multiplier by substituting the consumption function and equilibrium condition into the AE. Then use algebra to solve for the equilibrium GDP.

• Consequently, the multiplier = 1 / MPS

6. Equilibrium is stable

• At GDP ₁, Aggregate Expenditures exceeds GDP
  • Businesses and consumers are spending more than the amount of goods and services produced in the economy
  • Inventories are falling
  • Businesses increase their production of goods and services
• At GDP ₂, GDP exceeds Aggregate Expenditures
  • Businesses and consumers are spending less than the amount of businesses are producing
  • Inventories are increasing
  • Businesses decrease their production of goods and services
• When GDP = AE, economy is in equilibrium
  • Total leakages = Total injections
  • No unexpected changes in business inventories

Incorporaing Tourism into Aggregate Expenditures

1. Starting with the relationship, GDP = AE = C + Ig + G + Xn

• Tourism can lead to higher GDP
  1. Consumption - tourists buy goods and services
  2. Balance of Payments, Xn = Exports (X) - Imports (M)
     • Tourists are invisible exports
     • Tourist bring foreign currencies
     • Tourist buy local goods and services
  3. Investment - private companies invest in tourist infrastructure
  4. Government Spending - improve infrastructure in a region
     • Roads
     • Airport
     • Ports

2. Problems of tourism

1. Inflation
   • Tourism creates higher demand for land, property, and goods / services
   • International tourists will pay higher prices than domestic tourists
   • Price increases are usually permanent
   • Local population, especially ones not involved in tourism pay higher prices
2. Opportunity costs
   • If government invests in a tourist facility, program, or service, then the funding cannot be used for something else
   • Use cost-benefits analysis to determine if efficient
3. Dependency - reliance on a single industry
   • A decrease in tourists can have negative impacts on a country, if country overrelied on tourists
   • Use formula

• Example - Malaysia had approximately 22.4 million tourists in 2010
• 13.0 million tourists were from Singapore
• The dependency ratio is 58%
• Malaysia could have problems, if Malaysia falls out of favor from Singaporeans
4. Tourist destinations are sensitive to changes in demand
   • Wars, terrorism, and natural disasters scare tourists away
   • Examples
     • 2011 Riots in Egypt
     • SARS outbreak in China
     • Tsunami disaster in Thailand
5. Economic development from tourism is unequal
   • Tourist destinations developed economically
   • Surrounding areas may not develop
6. Seasonality
   • A tourist destination may have one or two peak seasons
   • Examples - Turkey, Greece, Eygpt, Spain, and Thailand
   • High season - opportunity to earn large profits
   • Low season - more difficult to earn profits
     • Workers idle for part of the year
     • Some facilities like hotels shut down for part of the year
     • Difficult to recoup investment
7. Leakages
   • Tourist industry may import some goods and services for tourists
   • Tourist industry may hire foreign workers
   • Tax revenue flows out of tourist region
   • Workers in tourist industry may be high savers
   • Foreign owned hotels and businesses send their profits out of a country

The Multiplier Effect for Tourism

1. Multiplier Effect for Tourism

• Direct effects - tourism spend money on transportation, hotels, restaurants, etc
• Indirect effects - generated from economic activity of subsequent expenditure
  • Hotels and restaurants purchase supplies and use local services
• Induced effects - arising from spending of income occurring to local residents from tourism wages and profits
  • Investment activity: arising from capital investment in new facilities for visitors
  • Government: public sector funding

2. Derivation of the tourism multiplier

• Start with the equations,
  • AE = C + G + Ig + X - M
  • C = A + (MPC)(GDP)
  • AE = GDP
  • M = (m)(GDP)
    • m is the portion of GDP that is imported
    • Also called the marginal propensity to import
    • Could be high for importing countries
• Assume - supply is elastic (or perfectly elastic); suppliers can meet the increase in demand

3. Income multipliers for several countries

• Small island countries have small multipliers
• Economy is small with high leakage

Source: Horwath Tourism & Lesisure Consulting. November 1981. Tourism Multiplier Explained.

4. Different types of multipliers

1. Sales Multiplier - the extra business turnover generated by an additional unit of tourist spending
2. Income Multiplier - the extra income generated from an additional unit of tourist spending
   • Could be defined as disposable income
   • Could Include the increase in tax revenue
3. Employment Multiplier - the extra employment created from an additional unit of tourist spending

Source: Horwath Tourism & Lesisure Consulting. November 1981. Tourism Multiplier Explained.

Tools for Estimating Tourism Impact

1. Input-Output Model - represent interdependencies among industries in an economy

• Wassily Leontief
• Very simple
• Requires high quality data
• Cannot handle changes in relative prices
• Capital and labor are used in fixed ratios
  • One worker for every machine
  • Standard production function - ratio of capital and labor can be varied
• No excess surplus of production; all products and services are consumed

• Example
  • Inputs to the tourism industry. Tourism uses 5 (billion) from agriculture, 10 (billion) from manufacturing, 15 (billion) from services, 5 (billion) from tourism industry, and 5 (billion) from imports.
• Total inputs = $40 (billion), which has to equal total outputs
  • Notice, exports = imports
  • Outputs to the tourism industry. Tourism has zero output to agriculture and manufacturing industries. However, services takes $20 (billion) in services, $5 (billion) in tourism, and $15 (billion) for exports.
    • Imports for tourism is a leakage
• Total GDP should be the summation of all industries, $505 (billion)
  • Tourism is 7.9% of economy

2. Cost-Benefit Analysis

• Applies to new investment projects
• List all the costs and benefits of project
• Typical time span is 10 years or longer
• Problems
  • Example - government has cost-benefits analysis to develop new beach
  • Estimate tourists
  • Private investment
  • Jobs created, etc.

Terminology