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Multiplier Effect

DEFINITION of 'Multiplier Effect'


The expansion of a country's money supply that results from banks being able to lend. The size
of the multiplier effect depends on the percentage of deposits that banks are required to hold as
reserves. In other words, it is money used to create more money and is calculated by dividing
total bank deposits by the reserve requirement.

INVESTOPEDIA EXPLAINS 'Multiplier Effect'


The multiplier effect depends on the set reserve requirement. So, to calculate the impact of the
multiplier effect on the money supply, we start with the amount banks initially take in through
deposits and divide this by the reserve ratio. If, for example, the reserve requirement is 20%, for
every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the
remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these
customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend
out the remaining $64. This cycle continues - as more people deposit money and more banks
continue lending it - until finally the $100 initially deposited creates a total of $500 ($100 / 0.2)
in deposits. This creation of deposits is the multiplier effect.
The higher the reserve requirement, the tighter the money supply, which results in a lower
multiplier effect for every dollar deposited. The lower the reserve requirement, the larger the
money supply, which means more money is being created for every dollar deposited.
multiplier effect definition

An effect in economics in which an increase in spending produces an increase in national income


and consumption greater than the initial amount spent. For example, if a corporation builds a
factory, it will employ construction workers and their suppliers as well as those who work in the
factory. Indirectly, the new factory will stimulate employment in laundries, restaurants, and
service industries in the factory's vicinity.
What is the multiplier effect?

The multiplier effect is a concept in economics that describes how an injection into an economy,
such as an increase in government spending, creates a ripple effect which increases employment
and the output of goods and services in the economy.
How does it work?
1. An injection occurs in the economy, such as an increase in government spending.
2. The injection increases the aggregate demand in the economy for goods and services.

3. The increase in demand for goods and services causes firms to employ more workers and
expand output.
4. As firms are employing more workers, more people have disposable incomes and subsequently
the aggregate demand increases in the economy.
5. The increases in aggregate demand causes firms to employ more workers and the effect
continues as before.
Key terms

Aggregate demand This refers to the total of all the demand in an economy. The equation for
aggregate demand is: Consumption (C) + Government Spending (G) + Investment (I) + (Exports
(X) Imports (M)).
Economy A system that provides goods and services.
Gross domestic product (GDP) This is the total value of all goods and services produced in an
economy during a set period of time.
Injections Injections increase the demand for domestically produced goods and services.
Injections come from investment, government spending and export sales.

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:

k=

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.

1
1-mpc

1
mpw

1. 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
2. Marginal Propensity to Withdraw (mpw). This is when money is withdrawn from the circular
flow it includes mpt + mpm + mps
3. The Marginal Propensity to Tax
(mpt)
4. The Marginal propensity to Import
(mpm)
5. The Marginal Propensity to Save
(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:

1. Firstly, if consumers maintain the same spending habits, they will have more disposable income
left over to buy more goods.
2. 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.

multiplier effect
An effect in economics in which an increase in spending produces an increase in national income and
consumption greater than the initial amount spent. For example, if a corporation builds a factory, it will
employ construction workers and their suppliers as well as those who work in the factory. Indirectly, the
new factory will stimulate employment in laundries, restaurants, and service industries in the factory's
vicinity.

Multiplier & Accelerator Effects


In this chapter we look at two ideas, the multiplier process and the accelerator effect, both of
which help to explain how we move from one stage of an economic cycle to another
What is the multiplier process?

An initial change in aggregate demand can have a much greater final impact on
equilibrium national income
This is known as the multiplier effect

It comes about because injections of new demand for goods and services into the
circular flow of income stimulate further rounds of spending in other words one
persons spending is anothers income
This can lead to a bigger eventual effect on output and employment

What is a simple definition of the multiplier?


It is the number of times a rise in national income exceeds the rise in injections of demand that
caused it
Examples of the multiplier effect at work

Consider a 300 million increase in capital investment for example created when an
overseas company decides to build a new production plant in the UK
This may set off a chain reaction of increases in expenditures. Firms who produce the
capital goods and construction businesses who win contracts to build the new factory will
see an increase in their incomes and profits
If they and their employees in turn, collectively spend about 3/5 of that additional
income, then 180m will be added to the incomes of others.

At this point, total income has grown by (300m + (0.6 x 300m).


The sum will continue to increase as the producers of the additional goods and services realize an
increase in their incomes, of which they in turn spend 60% on even more goods and services.
The increase in total income will then be (300m + (0.6 x 300m) + (0.6 x 180m).
Each time, the extra spending and income is a fraction of the previous addition to the circular
flow.
The Multiplier and Keynesian Economics

The concept of the multiplier process became important in the 1930s when John
Maynard Keynes suggested 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.
2.
3.
4.
5.

The propensity to spend extra income on domestic goods and services is high
The marginal rate of tax on extra income is low
The propensity to spend extra income rather than save is high
Consumer confidence is high (this affects willingness to spend gains in income)
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.

Multiplier Effect
Multiplier effect is a macro-economic phenomenon in which an initial change in spending results
in a greater ultimate change in real GDP. The initial change is usually a change in investment but
other components of GDP such as government spending, net exports and a change in
consumption which is not caused by change in income can also have multiplier effect on the
GDP.
The ratio of ultimate change in GDP to initial change in spending is called the multiplier and it is
represented using the following formula:
Change in Real GDP
Multiplier =
Initial Change in Spending

Reordering the above formula, we get,


Change in Real GDP = Multiplier Change in Initial Spending
So if an increase of $50 billion in investment increases real GDP by a multiplier of 5, the real
GDP will increase by $250 billion [= 505]. In this example, the multiplier effect is positive but
it can also occur in other direction as well i.e. decrease in initial spending reducing real GDP by
multiple times of initial decrease in spending.
Multiplier effect occurs under the assumption that the economy has room to expand so that
increase in spending does not result solely in inflation.

Explanation
Since the money spent in an economy is received by others as income and assuming that an
average person is likely to change their spending in direct proportion to their income, therefore

an initial increase or decrease in spending will start a chain of increased or decreased spending
by a number of people. The ultimate change in GDP will be the total of the incremental changes
in spending of multiple people caused by the initial change in spending.
Consider the example given above where the initial change in investment is $50 billion. This
initial investment increases GDP by $50 billion is first stage. The initial investment is received in
the form of income by a number people. Provided that they consume 80% of their income and
save the rest, $40 billion [=$500.8] of the initial investment will be spent in second stage. The
amount spent in second stage is also received by other people as income. In third stage, $32
billion [=$400.8] will be spent. In forth stage, $25.6 billion [=$320.8] will be spent. If we
continue this process long enough and add all the amounts together or, we can simply use the
following formula to calculate the total of this convergent geometric series:
Initial Change in Spending
Change in Real GDP =
1 MPC
$50 billion
Change in Real GDP =

= $250 billion
1 0.8

As you may have noted, the multiplier is related to percentage of total income spent by people
who directly or indirectly derive income from initial spending. This percentage is known as
marginal propensity to consume.

The Accelerator Effect


The accelerator effect is when an increase in national income results in a proportionately larger
rise in investment
Consider an industry where demand is rising at a strong pace.
Firms will respond to growing demand by expanding production and making fuller use of their
existing productive capacity. They may also choose to meet higher demand by running down
their stocks of finished products.
At some point and if they feel that the higher level of demand will be sustained they may
choose to increase spending on capital goods such as plant and machinery, factories and new
technology in order to increase their capacity. If this investment goes beyond what is needed
simply to replace worn out, fully depreciated machinery, then the capital stock of the business
will become larger.
In this sense, the demand for capital goods is being driven by the demand for the products that
the firm is supplying to the market. This gives rise to the accelerator effect - the principle states
that a given change in demand for consumer goods will cause a greater percentage change in
demand for capital goods.

A good example might be the surge in capital investment in wind turbines due to the super-high
level of oil and gas prices and a rising market demand for renewable energy. In this case, strong
demand created a positive accelerator effect. But this can also go into reverse e.g. during an
economic slowdown or recession. World oil prices have collapsed and many wind farm projects
have been scaled back or postponed.
Similarly the sharp fall in UK motor car production is also leading to a reverse accelerator
effect with planned investment spending subject to severe cut-backs and many jobs lost.
The Capital Output Ratio

The accelerator model works on the basis of a fixed capital to output ratio
For example if demand in a given year rises by 4 million and each extra 1 of output
requires an average of 3 of capital inputs to produce this output, then the net level of
investment required will be 12 million.

One criticism of this simple accelerator model is that the capital stock of a business can rarely be
adjusted immediately to its desired level because of adjustment costs and time lags. The
adjustment costs include the cost of lost business due to installation of new equipment or the
financial cost of re-training workers. Firms will usually make progress towards achieving an
optimum capital stock rather than moving smoothly from one optimal size of plant and
machinery to another.
A further criticism of the basic accelerator model is that it ignores the spare capacity that a
business might have at their disposal and also their ability to outsource production to other
businesses to meet a short term rise in demand.
The accelerator principle is used to help explain business cycles. The accelerator theory suggests
that the level of net investment will be determined by the rate of change of national income. If
national income is growing at an increasing rate then net investment will also grow, but when the
rate of growth slows net investment will fall. There will then be an interaction between the
multiplier and the accelerator that may cause larger fluctuations in the trade cycle.
The accelerator effect will tend to be high when

The rate change of consumer income and spending is strongly positive


The amount of spare productive capacity for businesses is low
The available supply of investment funds is high

multiplier
A number which indicates the magnitude of a particular macroeconomics policy measure. In
other words, the multiplier attempts to quantify the additional effects of a policy beyond those
that are immediately measurable. For example, a decrease in taxation will have more of an effect
than just the value of the reduced taxes. It will lead to greater disposable income which might
cause an increase in consumption, which in turn might increase employment in industries which
enjoy greater demand and so on. So the total effect of the implemented policy equals the effect of
the policy measure, times the multiplier. This is true of most macroeconmic policy measures,
because the actual effect of the measure cannot be quantified by the effect of the measure itself.

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 realworld 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.
So if an increase of $50 billion in investment increases real GDP by a multiplier of 5, the real
GDP will increase by $250 billion [= 505]. In this example, the multiplier effect is positive but
it can also occur in other direction as well i.e. decrease in initial spending reducing real GDP by
multiple times of initial decrease in spending.
Multiplier effect occurs under the assumption that the economy has room to expand so that
increase in spending does not result solely in inflation.

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.
When an autonomous component of Aggregate Demand changes, equilibrium output (Y) will
change. The change in output will be even larger than the initial change in Aggregate Demand.
This result for the change in Y to be greater than the initial change in Aggregate Demand is
known as the multiplier effect. For example, if the marginal propensity to consume (MPC) is
0.80 and autonomous investment increases by $200, equilibrium output will ultimately change
by $1,000, not $200!

Calculating the Size of the Multiplier Effect


The size of the multiplier effect is given by:

The simple output


multiplier = 1/(1MPC).

where the (simple) output multiplier is defined as 1/(1-MPC). For example, with
an MPC of 0.80, the simple output multiplier is 1/(1-0.80) = 5, so the $200 initial
increase in investment ultimately increases output by 5 x $200 = $1,000.

The simple output multiplier assumes there are no proportional taxes, all
expenditures are for domestically produced goods and services, and the
price level is fixed.

Income-induced
consumption is the
key to
understanding the
output multiplier.

How and Why the Multiplier Works


Consumption is based primarily on disposable income. When Aggregate
Demand rises, output and hence income rise. The rise in income allows people
to consume more goods and services. This is called "income-induced"
consumption and it raises Aggregate Demand even more.
TABLE 1
Initial Change Change in Change in
Round in Investment Output Consumption

Let's work through an


1
$100
$100.00
$80.00
example of the multiplier
process. Suppose the MPC
2
0
$80.00
$64.00
is 0.80. A University
decides to build a new
3
0
$64.00
$51.20
residence hall worth $100
million. Construction
4
0
$51.20
$40.96
workers earn $100 million
in income, and they spend
5
0
$40.96
$32.77
80 percent--or $80 million-dining out, going to the
6
0
$32.77
$26.21
movies, shopping, and
buying new cars. The
7
0
$26.21
$20.97
increased spending of $80
million becomes income to
8
0
$20.97
$16.78
the owners and employees
of the restaurants, movie
9
0
$16.78
$13.42
theatres, shopping malls,
and car dealers. In turn,
10 to inf.
0
$67.11
$53.69
these people spend 80
percent of the new $80
$100
$500
$400.00
million, or $64 million, on Totals
other goods and services.
The $64 million becomes income to others in the community, and the
process continues. Table 1 shows the impact of the multiplier through
various rounds. When all the effects are totaled up, output will increase by
$500 million because the value of the output multiplier is equal to 1/(10.8) = 5. Remember that the initial increase in Aggregate Demand for the
new residence hall was just $100 million.

The Output Multiplier with Proportional Taxes


One by one, we will relax the assumptions we made in calculating the simple
output multiplier. Let us start by introducing proportional taxes. A proportional
tax is a tax that varies with the level of income. An example is the income tax. If
income is taxed at a 20 percent rate, then t = 0.20, where t is the tax rate. Tax
revenue (T) is the total revenue collected from the tax. It is computed by the
formula:
T = t Y.

The formula for the output multiplier when proportional taxes are present,
is:
If MPC = 0.80, and t = 0.25, then the output multiplier
is
1/(1-0.80(1-0.25)) = 1/(1-0.6) = 1/0.4 = 2.5.

Proportional taxes
reduce the size of
the multiplier.

Proportional taxes reduce


TABLE 2
the size of the multiplier
because when there is, say,
Initial Change Change in Change in
$100 of new Aggregate
Round in Investment Output Consumption
Demand, an MPC of 0.8,
and a 25 percent tax rate,
1
$100
$100.00
$60.00
output increases in the first
round by $100 but
2
0
$60.00
$36.00
disposable income only
goes up by DI = Y - T =
3
0
$36.00
$21.60
$100 - (.25 100) = $75.
Consumers will spend 80
4
0
$21.60
$12.96
percent of that $75, or $60
in the first round. Taxes
5
0
$12.96
$7.78
diminish induced
consumption, which in turn
6
0
$7.78
$4.67
diminishes the impact on
output in the next round.
7
0
$4.67
$2.80
Total output now changes
by only $250, not $500.
8
0
$2.80
$1.68
Table 2 illustrates the
impact of the tax rate on
9
0
$1.68
$1.01
the multiplier effect of the
$100 million investment in
10 to inf.
0
$2.52
$1.51
the residence hall.
Totals

$100

$250

$150

The Output Multiplier with Imports


When domestic income rises, consumers wish to purchase more goods and
services. Some of the things they wish to consume are imports. When income

rises, demand for foreign goods and services also rises. This lowers demand for
U.S. goods & services and thus dampens the multiplier effect. We define the
marginal propensity to import (MPI) as the change in imports divided by the
change in disposable income. For example, suppose the MPI = 0.05. If
disposable income (DI) rises by $100, imports will rise by $5.
The propensity to
import tends to
lower the multiplier
effect.

Assuming no proportional taxes but including imports, the output


multiplier formula is:
With an MPC = 0.8 and MPI = 0.05,
the value of the output multiplier is
1/(1 - 0.8 + 0.05) = 1/0.25 = 4.
Like taxes, the propensity to import tends to lower the multiplier effect because
demand for domestically produced final goods and services falls.

An Interactive Example
Below are two interactive tables that compute the value of the output multiplier
and display the impact of the multiplier through ten rounds. Enter in values for
the MPC (it must be between 0 and 1), the tax rate (between 0 and 100), and
the initial change in Aggregate Demand. Then click the "Compute" button. The
"Reset" button resets all the numbers to their default values.
Output Multiplier
MPC (between 0 and 1):
Tax rate (as %):
Initial Change in AD:
Multiplier:

Rounds of the Multiplier


Round

Initial Change Change Induced change


in AD
in Y
in Consumption

1
2
3
4
5
6
7
8
9
10
Total

A rising price level


also tends to
reduce the value of
the multiplier.

The Output Multiplier with Price Level Changes


Just for this section, we will relax the
assumption of fixed prices. The figure
titled "Multiplier with Price Level
Changes" assumes that the Aggregate
Supply curve is upward sloping instead
of perfectly horizontal. When the
Aggregate Demand curve shifts and
the Aggregate Supply curve is upward
sloping, the multiplier effect is smaller.
The economy moves from point A to
point C, instead of going to point B
when the Aggregate Supply curve is horizontal. The smaller effect results
because Aggregate Demand is partially dampened as the price level rises. With
an upward sloping Aggregate Supply curve, the impact of an increase in

Aggregate Demand goes towards higher output and prices. In the extreme case
of a perfectly vertical Aggregate Supply curve, the output multiplier is zero.

The Multiplier Effect and a Temporary Change in Aggregate Demand


Recall that the multiplier effect is calculated by:

Temporary
expenditures flow
through the
economy, but they
do not have a
permanent effect
on the equilibrium
level of output.

The dynamic impact of the multiplier depends upon whether the change in
Aggregate Demand is temporary (a one-time expenditure), or permanent (a
permanent period after period increase in Aggregate Demand). For example, if a
government repairs a road, the injection into the economy is temporary. When
the road is finished, the new government injections into the economy stop. The
expenditures on the road will flow through the economy, but they will not
continue indefinitely.

On the other hand, the construction of a new public school building or a


new jail is more permanent. The government expenditures continue even
after construction of the building is completed. New jobs for teachers,
staff, and administrators will be created and the government must continue
to pay income to these workers year after year. First, we examine the
multiplier effect when the initial injection of Aggregate Demand is
temporary.
Suppose the government spends
$100 to repair an existing road,
injecting $100 temporarily into the
economy. The multiplier effect
occurs over a period of time.
Assuming no taxes or imports and
an MPC of 0.8, an increase in
government expenditures of $100
ultimately increases output by a
total of $500, but the increase in
output will not occur all at once. As
the figure titled "AD/AS Response
to Temporary Change in AD" illustrates, initially, AD0 and AS intersect.
The one-time $100 increase in Government Expenditures in round 1 shifts
the Aggregate Demand curve to the right (AD1). After this expenditure,
Government Expenditures decline by $100 because the road repair project

is completed. The increase in income from the road improvement


increases consumption and output in round 2, but only by 0.8 $100,or
$80. So output is actually $20 lower compared with the previous round.
The intersection of AD2 and AS gives the level of output in round 2. The
process continues in round 3, and again in round 4. Each time the
Aggregate Demand curve shifts to the left. Eventually, the Aggregate
Demand curve will exactly overlie the original AD0curve, and the
multiplier effect will be completed. A useful analogy is to think of a stone
thrown into a still lake. The initial impact makes the biggest splash and
then the impact ripples through the water in successively smaller waves.
Eventually, the water returns to its initial peaceful condition.
Because of the road repair
expenditures, equilibrium
output rises, but the impact
dampens out overtime. The
figure titled "Change in
Output from Temporary
Change in AD" shows the
change in equilibrium output in
each round. Notice that the
change in equilibrium output
asymptotically returns to zero.

The Multiplier Effect and a Permanent Change in Aggregate Demand

Permanent
expenditures have
a lasting effect on
the equilibrium
level of output.

If the government(or any private


investor) funds an on-going project
like financing a school, the impact
is much larger than that of a
temporary spending increase.
Suppose for simplicity that the
government spends $100 to
construct a new school and then
spends $100 each year to operate
the school. The government is
injecting $100 into the economy
permanently.

As the figure titled "AD/AS


Response
to
Permanent
Change in AD" illustrates, in
the first round, output increases
by $100 due to the initial
change
in
government
spending. The higher output
and, hence, higher income
induces $80 more consumption
spending (assuming an MPC of
0.8, and no imports or taxes). If the government expenditure is permanent,
total output rises in the second round by $180 ($100 of government
expenditures plus $80 for the induced consumption). In the third round,
consumption increases again by an additional $64 ($80 x 0.8), so output
increases by $100 + $80 + $64,or $224. The process continues with each
successive increase in output becoming smaller and smaller until the
incremental change in output is zero. However, the overall equilibrium
level of output in the community will be $500 (5 x $100) higher than
before the school was built and operated. The cumulative impact on the
equilibrium level of output is illustrated in the figure titled "Change in
Output from Permanent Change in AD."

Conclusion
The multiplier almost seems magical, in that the economy is getting something
for nothing. Not so. The multiplier process is the result of numerous businesses
and individuals increasing their production activities to take advantage of
potential profit opportunities.

Although the multiplier process can be a powerful force of economic


expansion or contraction, we must keep in mind that the process occurs
primarily in the short run. Imagine a city with a fully employed labor force
that builds a new high school out in the suburbs. The spending for the high
school creates multiplier effects as teachers and staff earn income and then
spend that income on other things in the community. If the teachers and
staff at the new high school, however, came from a city high school which
was closed, then the overall multiplier effect on the region is much smaller
(and may even be zero) because income in the community where the
school was closed is less. The multiplier effect has its greatest impact
when idle resources exist.

Multiplier is a pure number used to multiply a given change in investment to find


the resulting change in income
Multiplier the multiple by which an initial change in aggregate spending will alter
total expenditure after an infinite number of spending cycles
The larger the size of the multiplier, the greater is the expected inflationary impact.
This is so, because the buildup of greater demand is dependent on the size of the
multiplier.
The value of the multiplier depends on the value of the MPC. The higher the MPC,
the higher is the value of the multiplier.
Multiplier a term in macroeconomics denoting a change in an induced variable,
such as (GNP or money supply) per unit of change in an external variable, such as
(government spending and bank reserves)
Aggregate Demand the total quantity of output demanded at alternative price
levels in a given time period
Consumption function a mathematical relationship indicating the rate of desired
consumers spending at various income levels
Leakage income not spent directly on domestic output, ex. savings, imports,
taxes
If leakages exceed injections, the economy contracts
The circular flow of income has several leaks in it. Income diverted into consumer
saving, business saving (retained earnings and depreciation), taxes or imports
reduces the value of the circular flow
Other autonomous spending injects income into the circular flow. These injections
come from investment, export sales and government spending
If injections exceed leakages, the economy expands
Investment expenditures on new plant and equipment in a given time period, plus
changes in business inventories
Investment represents an injection into the circular flow that may offset the
leakage caused by consumer saving
Recessionary gap the amount by which desired spending at full employment falls
short of full employment output

Recessionary gap is the amount by which the total value of goods supplied at full
employment exceeds the total value of goods demanded
Recessionary gap implies that desired saving exceeds desired investment
A recessionary gap may lead to a cutback in production and income. A reduction in
total income will in turn lead to a reduction in consumer spending. This additional
cuts in spending cause a further decrease in income, leading to additional spending
reductions and so on. This sequence of adjustments is referred to as the multiplier
process.
Recessionary gap is the origin of cyclical unemployment
Inflationary gap the amount by which desired spending at full employment
exceeds full employment output
The existence of an inflationary gap implies that desired investment exceeds
desired saving