Multiplier Effect

Published Jan 5, 2023

Definition of Multiplier Effect

The multiplier effect is an economic concept that describes how an initial increase in spending can lead to a much larger increase in total national income. That means it is a process in which an increase in spending due to expansionary fiscal policy produces an even greater increase in national income and consumption. This effect is caused by the fact that when people receive more income, they spend a portion of it on goods and services, which in turn generates income for others.

The multiplier can be calculated as 1/(1-MPC), where MPC is the marginal propensity to consume.

Example

To illustrate the multiplier effect, let’s look at a simple example. Imagine the government decides to increase spending on infrastructure projects by $100 million. This money is used to hire workers, buy materials, and pay for other services. As a result, the workers and suppliers receive additional income. Now, let’s assume that the workers and suppliers spend 80% of their additional income on goods and services (i.e., that’s their marginal propensity to consume). That means they spend $80 million. This additional spending then generates income for other people, who in turn spend 80% of their income, and so on. This process continues until all the money has been spent.

In this example, the initial increase in spending of $100 million will result in a total increase in national income of $500 million. That means the multiplier effect has increased the total national income by a factor of five (i.e., 1/[1-0.8]).

Why Multiplier Effect Matters

The multiplier effect is an important concept in macroeconomics. It helps to explain how an initial increase in spending can lead to a much larger increase in total national income. This effect is especially relevant in times of economic recession when governments often try to stimulate the economy by increasing spending. By understanding the multiplier effect, policymakers can better assess the potential impact of their actions and make more informed decisions.