The multiplier effect refers to the increase in final income arising from any new injection of
spending.
How does the multiplier effect 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.
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 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 can also be calculated by adding up all of the withdrawals or leakages in
the economy. Remember the leakages are:
1. Savings (marginal propensity to save.)
2. Taxes or extra income going to the government (marginal propensity to tax)
3. Money spent on imports (marginal propensity to import)
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
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 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.
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.
For Example:
Many governments in developed nations have been introducing fiscal austerity programmes
– cutting spending and lifting taxes in a bid to lower their budget deficits. The fiscal
multiplier effect is important here too. If the multiplier is 0.5, then an initial government
expenditure reduction of 1 per cent of GDP reduces real output by 0.5 percent. If, however,
the multiplier is 1.7, then the same initial public spending cut of 1 per cent of GDP would
reduce real output by 1.7 per cent. The big danger of a high fiscal multiplier is that a period
of deep cuts in state spending will cause an even larger drop in GDP which in turn will
increase the size of the budget deficit. Fiscal austerity can turn out to be self-defeating.
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.