Multiplier (economics)

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In economics, a multiplier effect – or, more completely, the spending/income multiplier effect – occurs when a change in spending causes a disproportionate change in aggregate demand. It is particularly associated with Keynesian economics; some other schools of economic thought reject or downplay the importance of multiplier effects particularly in the long run.

1 Overview
2 Details
3 References
4 links

[edit] Overview

fig. 1 - The Simple Multiplier Process. (mpc=marginal propensity to consume)

The basic assumption of the multiplier effect is that the economy starts off with unused resources, for example, that many workers are cyclically unemployed and much of industrial capacity is sitting idle or incompletely utilized. By increasing demand in the economy it is then possible to boost production. If the economy was already at full employment, with only structural, frictional, or other supply-side types of unemployment, any attempt to boost demand would only lead to inflation. For various laissez-faire schools of economics which embrace Say's Law and deny the possibility of Keynesian inefficiency and under-employment of resources, therefore, the multiplier concept is irrelevant or wrong-headed.

As an example, consider the government increasing its expenditure on roads by $1 million, without a corresponding increase in taxation. This sum would go to the road builders, who would hire more workers and distribute the money as wages and profits. The households receiving these incomes will save part of the money and spend the rest on consumer goods. These expenditures in turn will generate more jobs, wages, and profits, and so on with the income and spending circulating around the economy.

The multiplier effect arises because of the induced increases in consumer spending which occur due to the increased incomes -- and because of the feedback into increasing business revenues, jobs, and income again. This process does not lead to an economic explosion not only because of the supply-side barriers at potential output (full employment) but because at each "round", the increase in consumer spending is less than the increase in consumer incomes. That is, the marginal propensity to consume (mpc) is less than one, so that each round some extra income goes into saving, leaking out of the cumulative process. Each increase in spending is thus smaller than that of the previous round, preventing an explosion.

[edit] Details

Here, the marginal propensity to consume equals:

mpc = ΔC/ΔY

where C is consumer spending and Y is consumer disposable income.

If the multiplier process is going LL downward, as in a recession, the fall in demand creates its own unused resources, so that the basic assumption of the theory applies.

The eventual amount by which output expands is governed by the marginal propensity to save (mps), which is the proportion of income saved to the net consumer disposable income. If the marginal propensity to save is large, less money is returned into the economy with each circulation so the multiplier effect is smaller. The value of the multiplier in a closed economy with no taxes is given by

mult = 1/(1 – mpc) = 1/mps

This is also known as Autonomous Spending Multiplier. ^[1]

In the Keynesian model, mps equals one minus the mpc. (Note that the mps cannot equal zero, nor can the mpc equal one.)

In this simple model, the multiplier can be used to predict changes in GDP (Y) for a given change in spending, X.

predicted ΔY = mult * ΔX

Of course, the validity of this equation depends of the validity of the assumptions of the model.

This is also true of the formula for the multiplier. Taxes and imports tend to reduce the value of the multiplier ("leakage"). With these, the spending/income multiplier process is more complex, as seen in figure 2, above.

mult = 1/mlr

This formula of the multiplier is obtained when we take into account the effects of all leakages, which combine into the 'Marginal Leakage Rate' (mlr) from the circular flow. (Again, mlr cannot equal zero.)

The value of the multiplier is also lower, less than 1/s, since some of the demand stimulus or restraint leaks out to affect imports from the rest of the world and tax revenues. This weakening occurs because imports do not lead automatically to spending on the country's exports and increased tax revenues do not automatically cause increased government spending. Though this reduces the value of mult, it does not undermine the validity of the third equation above.

The multiplier shows that changes in the level of spending do not just have a 'one off' effect on the level of income, because "one man's spending is another man's income."

This is illustrated in the chart below. Note that the size of the multiplier depends upon how much of their extra income consumers are willing to spend.

In this case, MPC = 0.8