When money is spent in an economy, this spending results in a multiplied effect on economic output.

This lesson explains the multiplier effect and the how to use the simple spending multiplier to
calculate it.

The Multiplier Effect

In the economy, there is a circular flow of income and spending. Everything is connected. Money that
is earned flows from one person to another, and most of it gets spent again - not just once, but many
times. What this means is that small increases in spending from consumers, investment or the
government lead to much larger increases in economic output. Economists use formulas to measure
how much spending gets multiplied. To illustrate this, let's take a look at a very simple economy,
featuring these four familiar faces:

Bob, the lawn service guy, who also does landscaping when his customers are interested
Lydia, a neighbor who works on an assembly line in a car factory

Frank, who is a farmer

Davis, who recently moved into the neighborhood and works at the hardware store

Lydia's factory has a great year, and as a result, she earns an additional $1,000 of income. Lydia,
very eager to satisfy her own needs and wants, spends $800 of it on new landscaping for her yard.
Since Bob is in the landscaping business, that means Bob earns an additional $800. Since Bob also
has needs and wants, he spends $600 of that $800 at Frank's farm store. This money is additional
income to Frank the farmer, and guess what he does with it? He goes and talks to Dave and spends
most of it, let's say $500, at the hardware store. As you can see, the initial $1,000 round of spending
actually led to three more rounds of spending, with smaller amounts each time. In this case, $1,000
of spending from Lydia led to an increase in economic output of $1,000 + $800 + $600 + $500 =
$2,900.
When money spent multiplies as it filters through the economy, economists call it the multiplier
effect. Money spent in the economy doesn't stop with the first transaction. Because people spend
most of the extra income they get, money flows through the economy one person at a time, like a
ripple effect when a rock gets thrown into the water. I'm sure you can remember a time when you
were standing next to a pond or a lake, and when you threw a rock in, you gazed at the ripple effect
that took place around the rock as it entered the water. Spending in the economy is like this.
The question we want to answer is this: how do we measure this ripple effect? Here's a real-world
example that happens more often than you might think. Let's say that the economy is in recession,
and consumers like Lydia have stopped spending money, so economic output has gone down.

The components of GDP

It just so happens that you are working in Congress. You're on the committee that's working on a bill
to increase government spending. Why would you want to do that? Because the economy is in
recession, and government spending is one of the components of economic growth. You know that if
consumers like Lydia have stopped their spending, that maybe some government spending will help
increase the output of the economy. It will ripple through the rest of the economy, and maybe Lydia
can get the landscaping that she desperately wants after all. What you really want to know at this
point is: how much will output increase if government spending increases by $1 billion?
At first glance, you might think that output will increase by exactly the same amount as government
spending increases, but you'd be incorrect. When the government spends money, firms profit. When
firms profit, workers take home more income, which then gets spent. Because of this multiplier effect,
output goes up by a much larger number. We can find out how much by using what economists call
the simple spending multiplier.

The MPC and the MPS

The simple spending multiplier shows us how much economic output increases with an increase
in spending. Economists ask the question this way: how much did real GDP change when a
component of aggregate demand changed?
To understand the simple spending multiplier, you also need to understand how likely people are to
spend versus save any extra income they get, because this determines how big the multiplier effect
will be. Economists call these two other concepts the marginal propensity to consume and the
marginal propensity to save.
The marginal propensity to consume is the percentage of extra income that consumers spend.
Economists call it MPC for short. So, if the MPC is 80%, that means consumers are likely to spend
(or consume) 80% of any extra income they get.
The marginal propensity to save is the percentage of extra income that consumers save.
Economists call it MPS for short. It's basically the inverse of the marginal propensity to consume.
Because we're talking about a percentage of income, both of these percentages will always add up
to 100%, or 1.0.
The easy way to think of this is to say that whatever the MPC is, subtract this amount from 1 and you
get the MPS. The MPS is 1 minus the MPC. For example, if the marginal propensity to consume is
0.8 (which is 80%), then that means the marginal propensity to save must be 0.2 (or 20%). When the
MPC is 0.85, on the other hand, then the MPS must be 0.15, et cetera.
The MPS is actually one of the components of the simple spending multiplier, which is why we need
it right now.

Formula for the Simple Spending Multiplier

The formula for the simple spending multiplier is 1 divided by the MPS.

Let's try an example or two. Assume that the marginal propensity to consume is 0.8, which means
that 80% of additional income in the economy will be spent. What we want to know is: what is the
maximum amount that real GDP could change if government expenditures increase by $1 billion?
First, we find the marginal propensity to save, which is always 1 minus the marginal propensity to
consume. The marginal propensity to consume is 0.8. So, 1 minus the MPC is going to be 1 - 0.8,
which is 0.2.

Spending Multiplier
Spending multiplier (also known as fiscal multiplier or simply the multiplier) represents the multiple by
which GDP increases or decreases in response to an increase and decrease in government
expenditures and investment. It is the reciprocal of the marginal propensity to save (MPS). Higher the
MPS, lower the multiplier, and lower the MPS, higher the multiplier.
The spending multiplier is closely related to the multiplier effect. Assume that households consume
80% of any increase in their income and that the government increases its expenditure by $20 billion.
Any government expenditure is actually income of households in the form of wages, interest, rent and
profit. Since MPC is 0.8, households will consume $16 billion of the increased income (= 0.8
$20billion). The $16 billion increase in consumption will trigger second round of increase in incomes
(for people associated with production of the consumed products and services) which in turn will
trigger second round of consumption amounting to $12.8 billion (= 0.8 0.8 $20 billion), and so
on. The resulting effect is that the GDP increases by a multiple of initial increase in government
expenditures. This multiple is the spending multiplier. A decrease in government expenditures
decreases GDP by a multiple in the same fashion.

Formula
Spending Multiplier =

1
1
=
MPS
1 MPC

Where,
MPS stands for marginal propensity to save which is the percentage of any addition in income which
households are going to save; and

MPC stands for marginal propensity to consume and it is the percentage of any addition in income
which households are expected to consume.
By definition, MPS + MPC = 1 and MPS = 1 MPC.

Examples
Example 1: Lucre Island is a pirate country in which people rarely plan. They are known to spend
whatever they can grab.
Since the country have a marginal propensity to consume of almost 100%, marginal propensity to
save is 0 (= 1 100%), which gives us an infinite spending multiplier (1 0 = )
Example 2: Khembalung is a country home to Buddhist monks. They live an extremely simplistic life,
and though the country is replete with precious stones, the monks are rarely interested in any luxuries
and they have almost zero marginal propensity to consume.
The country has a marginal propensity to consume of almost 0, which gives us a marginal propensity
to save of 1 and a spending multiplier of 1. This means that there is no multiplier effect.
Example 3: Average per capita income in Anvilania rose from $42,300 dollars to $50,000 while
corresponding figures for per capita consumption rose from $35,400 to $42,500. Find the spending
multiplier.
Solution

MPC =

Increase in Consumption
42,500 35,400
=
= 92.2%
Increase in Income
50,000 42,300

MPS = 1 MPC = 1 92.2% = 7.8%

Spending Multiplier = 1 = 1 = 12.82

The multiplier effect

Every time there is an injection of new demand into the circular flow there is
likely to be a multiplier effect. This is because an injection of extra income
leads to more spending, which creates more income, and so on. The multiplier
effect refers to the increase in final income arising from any new injection of
spending.
The size of the multiplier depends upon households marginal decisions to
spend, called the marginal propensity to consume (mpc), or to save,
called the marginal propensity to save (mps). It is important to remember that
when income is spent, this spending becomes someone elses income, and
so on. Marginal propensities show the proportion of extra income allocated to
particular activities, such as investment spending by UK firms, saving by
households, and spending on imports from abroad. For example, if 80% of all
new income in a given period of time is spent on UK products, the marginal
propensity to consume would be 80/100, which is 0.8.
The following general formula to calculate the multiplier uses marginal
propensities, as follows:

1/1-mpc
Hence, if consumers spend 0.8 and save 0.2 of every 1 of extra income, the
multiplier will be:

1/1-0.8
= 1/0.2
=5
Hence, the multiplier is 5, which means that every 1 of new income
generates 5 of extra income.

The multiplier effect in an open economy

As well as calculating the multiplier in terms of how extra income gets spent,
we can also measure the multiplier in terms of how much of the extra income
goes in savings, and other withdrawals. A full open economy has all sectors,
and therefore, three withdrawals savings, taxation and imports.
This is indicated by the marginal propensity to save (mps) plus the extra
income going to the government - the marginal tax rate (mtr) plus the amount
going abroad the marginal propensity to import (mpm).
By adding up all the withdrawals we get the marginal propensity to withdraw
(mpw). The multiplier can now be calculated by the following general equation:

1/1- mpw

Applying the multiplier effect

The multiplier concept can be used any situation where there is a new
injection into an economy. Examples of such situations include:
1. When the government funds building of a new motorway
2. When there is an increase in exports abroad
3. When there is a reduction in interest rates or tax rates, or when the
exchange rate falls.

The downward or 'reverse'multiplier

A withdrawal of income from the circular flow will lead to a downward multiplier
effect. Therefore, whenever there is an increased withdrawal, such as a rise in
savings, import spending or taxation, there is a potential downward multiplier
effect on the rest of the economy.

The Multiplier and Keynesian Economics

The concept of the multiplier process became important in the 1930s when John
Maynard Keynessuggested it as a tool to help governments to maintain high
levels of employment
This demand-management approach, designed to help overcome a shortage of
capital investment, measured the amount of government spending needed to
reach a level of national income that would prevent unemployment.

Factors that affect the value of the multiplier effect

The higher is the propensity to consume domestically produced goods and

services, the greater is the multiplier effect. The government can influence the
size of the multiplier through changes in direct taxes. For example, a cut in the
rate of income tax will increase the amount of extra income that can be spent on
further goods and services
Another factor affecting the size of the multiplier effect is the propensity to
purchase imports. If, out of extra income, people spend their money on
imports, this demand is not passed on in the form of fresh spending on
domestically produced output. It leaks away from the circular flow of income and
spending, reducing the size of the multiplier.

The multiplier process also requires that there is sufficient spare capacity for extra
output to be produced.
If short-run aggregate supply is inelastic, the full multiplier effect is unlikely to
occur, because increases in AD will lead to higher prices rather than a full increase in
real national output. In contrast, when SRAS is perfectly elastic a rise in aggregate
demand causes a large increase in national output.
In short the multiplier effect will be larger when
1. The propensity to spend extra income on domestic goods and services is high
2. The marginal rate of tax on extra income is low
3. The propensity to spend extra income rather than save is high
4. Consumer confidence is high (this affects willingness to spend gains in income)
5. Businesses in the economy have the capacity to expand production to meet
increases in demand
Time lags and the multiplier effect

It is important to remember that the multiplier effect will take time to come into
full effect
A good example is the fiscal stimulus introduced into the US economy by the
Obama government. They have set aside many billions of dollars of extra
spending on infrastructure spending but these sorts of capital projects can take
years to be completed. Delays in sourcing raw materials, components and finding
sufficient skilled labour can limit the initial impact of the spending projects.

Calculating the value of the multiplier

The formal calculation for the value of the multiplier is
Multiplier = 1 / (sum of the propensity to save + tax + import)
Therefore if there is an initial injection of demand of say 400m and

The marginal propensity to save = 0.2

The marginal rate of tax on income = 0.2

The marginal propensity to import goods and services is 0.3

Then the value of national income multiplier = (1/0.7) = 1.43

An initial change of demand of 400m might lead to a final rise in GDP of 1.43 x 400m
= 572m
If

The marginal propensity to save = 0.1

The marginal rate of tax on income = 0.2

The marginal propensity to import goods and services is 0.2

The value of the multiplier = 1/0.5 = 2 the same initial change in aggregate demand
will lead to a bigger final change in the equilibrium level of national income.

You are here: Home > Economics help blog > The Multiplier Effect
The Multiplier Effect

by Tejvan Pettinger on November 2, 2011 in economics

The fiscal multiplier effect occurs when an initial injection into the economy causes
a bigger final increase in national income.

For example, if the government increased spending by 1 billion, there would be an

initial increase in Aggregate Demand of 1bn. However, if this injection eventually
caused real GDP to increase by 2 billion, then the multiplier would have a value of
2.0

Multiplier (k)

Change in Real GDP (Y)

Change in Injections (J)

Example of How the Multiplier Effect Works

If the government spent an extra 2 billion on the NHS this would cause salaries /
wage to increase by 2 billion, therefore National Income will increase by 2 billion.
However with this extra income, workers will spend, at least part of it, in other areas
of the economy.
For example, if they spent 50% of the extra income there would be another 1
billion injected into the economy. e.g. shopkeepers would earn money from
increased sales.
This extra spending would cause an increase in output, therefore firms would
employ more workers and pay higher salaries.
Therefore these workers will also increase their spending. This will lead to another
injection into the economy, causing higher Real GDP
In other words, if you increase salaries in the NHS, it isnt just NHS workers who
benefit from higher incomes. It is also related industries and service industries who
see some benefits.
AD = C + I + G + X M

Injections can include:

Investment (I)
Government Spending (G)
Exports (X)
Negative Multiplier Effect
The multiplier effect can also work in reverse. If the government cut spending, some
public sector workers may lose their jobs. This will cause an initial fall in national
income. However, with higher unemployment, the unemployed workers will also
spend less leading to lower demand elsewhere in the economy.

The value of the Multiplier depends upon:

If people spend a high % of any extra income, then there will be a big multiplier
effect.
However if any extra money is withdrawn from the circular flow the multiplier effect
will be very small.
k=

1
1-mpc

1
mpw

Marginal Propensity to Consume (mpc). This is a persons willingness to spend

money, if a worker saved all his money there wouldnt be an increase in GDP
Marginal Propensity to Withdraw (mpw). This is when money is withdrawn from the
circular flow it includes mpt + mpm + mps
The Marginal Propensity to Tax
The Marginal propensity to Import
The Marginal Propensity to Save

(mpt)
(mpm)
(mps)

The multiplier will also be effected by the amount of spare capacity if the economy
is close to full capacity an increase in injections will only cause inflation.

Multiplier Effect of a Tax Cut

A tax cut has no effect on government spending, but, it should effect Consumer
spending (C) and I (investment)
For example, imagine the government cut VAT from 17.5% to 15%. This has two
effects:
Firstly, if consumers maintain the same spending habits, they will have more
disposable income left over to buy more goods.
Secondly, they may be encouraged to buy goods (especially expensive electrical
goods) e.t.c because they are cheaper.
Therefore, in theory, a tax cut should boost consumer spending and this leads to an
overall rise in AD.
This means firms will get an increase in orders and sell more goods. This increase in
output, will encourage some firms to hire more workers to meet higher demand.
Therefore, these workers will now have higher incomes and they will spend more.
This is why there is a multiplier effect. Extra spending benefits others in the
economy.
Crowding Out
Monetarists argue the fiscal multiplier will be limited by the crowding out effect. E.g.
if the government increase Aggregate Demand through higher spending or tax cuts
then this increases consumer spending. However, the rise in borrowing (and higher
bond yields) leads to a decline in private sector investment. Therefore, there is no
overall increase in AD.

Keynesian View on Crowding out and Multiplier

However, in a recession, Keynesians argue that the private sector typically has a
glut of non productive savings, therefore, the crowding out effect is limited and
there will be a positive multiplier effect.