The Multiplier Effect
Government Investment and a Deflationary Gap
 Remember: Government spending and business
investment are injections into the circular flow of
income.
 Any injections are MULTIPLIED through the
economy.
 How does this take place?
Multiplier Example
 A government spends 100m dollars on a school
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building project.
This 100m goes to a vast number of people for the
factors of production they provide. (ex?)
Labour in the form of Architects, engineers, builders
etc.
So the 100m goes into the pockets of these people.
What do people do with this income?
Spending
 Some of it goes back to the government as taxes.
 Some is saved.
 Some is spent on foreign goods.
 The rest is spent on domestic goods and services.
 The first 3 are withdrawals from the circular flow of
income, why?
What happens to the money spent domestically?
 These new recipients of the income behave in a
similar fashion.
 They pay taxes, they save, the buy imports and the
rest is spent on domestic produce.
 During each “round” some income is withdrawn
from the circular flow and the rest stays to be respent.
Simple example
 Govt. spends 100m on an economy in an attempt to
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stimulate spending and increase GDP.
Of that 100m,
20% goes on taxes
10% is saved
10% is spent on imports
Remaining 60% spent on domestic goods
Marginal Propensity to Comsume or MPC
 So the MPC when expressed as a decimal is 0.6
 The final result of the multiplier, when all the money
has been spent and re-spent amounts to 250m or 2.5
times the original government spending of 100m.
 With example of an economy, any injection would
contribute 2.5 times its amount to national income.
Formulas
 MPC=Marginal Propensity to Consume
 MPW=Marginal Propensity to Withdraw
 MPW=Marginal Propensity to Save (MPS) +
Marginal Rate of Taxation MRT + Marginal
Propensity to Import MPM… or
 MPW=MPS+MRT+MPM
1
1
1
 1-MPC or MPS+MPM+MRT = MPW
Elasticity
 How large an effect will the multiplier have?
 Depends on the elasticity of supply.
 If there is plenty of “spare capacity” in an economy
then the supply will be far more elastic and that will
mean a larger effect.
 If we are close to full capacity with an inelastic PES
then the multiplier’s effect lessens.
Example Questions
 Work out the National Income increase of these 3
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different economies if 50 million dollars is invested
in each.
Country A has an MPC of .75
Country B has an MPC of .80
Country C has an MPC of .50
In which country would the greatest degree of GDP
increase take place?
Withdrawals
 Work out the National Income increase of the
economy below if 100 million dollars is invested and
it’s MPW is as follows:
 MPS=0.2
 MPT=0.3
 MPM=0.3