The multiplier effect in economics shows by how much or by how many times the final income would increase if an initial injection of investment/spending is done, known as multiplier effect.
How does multiplier effect occur in an economy?
Holding a thought on the occurrence of multiplier process and effect, let’s see this scenario to make it more understandable.
The government wants to build hundreds of hospital in a near town, he gives a call to all the builders and injects about $500 million in that project. From the investment of government let’s see how multiplier effect occurs. All the builders demands for $500 million of inputs to proceed the project.
From this move, many companies, industries, businessman benefits by supplying their goods and services like labor work, industrial materials, machinery etc. The supply of all these materials and physical services will generate flow of income and profits in return. And it will keep floating in the circular flow with the aim of generating more income which as a result will attempt to cause the economic activity to be in action.
The moving circular flow indicates that economic activity in a nation is actively working and generating huge amount of National income or GDP, which is the Multiplier effect that have put a bigger impact on the income of nation from an injection of investment.
These all processes can come in account when an injections of new demand for goods and services happens in the circular flow of income and this activates added rounds of spending.
This process finally leads to a bigger effect on national output and employment which is known the concept of multiplier.
What determines the size of multiplier?
There are few things that determines the size of the multiplier effect. Spending in the economy is like to throw a stone in pond, the deeper you will throw it, the bigger will be the waves spreading over. To figure out what makes the multiplier to leave bigger effect.
Let’s just say that economy is in the recession and people have stopped spending.
Now it turns to government to invest for public wants. Since people have stopped spending, government spending at this time may help to increase output of the economy as it is the part of economic growth and it will riffle through the rest of the economy.
After the Government is done with its injection, lets say by how much output increases if government spending increases by $1 billion? At first class you might think that higher government will spend, higher will be the output but you might get it wrong. It’s far away from just increase in output in multiplier.
When the government spends money, firms receive profit, and the worker is paid well that consequently make a household spend more. This flow of income is the reason that the multiplier effect takes output at much larger number.
Economist ask this question this way, how much does Real GDP changes when a component of aggregate demand change? To know this you should understand, how likely people spend vs. extra income. Because these factors determines the multiplier impact. Economist call these two concepts as Marginal Propensity to Consume and Marginal Propensity to save and import.
Calculating the multiplier effect
- MPC: The percentage of extra income that consumers spend, called MPC in short.
- MPS: the percentage of extra income that consumers save.
- MPI: the percentage of extra income that consumers import.
To be specific, the multiplier effect would be larger when:
- When extra income preferred to spend more on the domestic products.
- The tax on that good and services is reduced.
- When the MPS will be lower from the MPC
- Consumer’s willingness to spend their money in the market.
- When MPI is low.
We can express the relationship between the expenditure as per income increase in a very systematic way by the help of Marginal propensity to consume.
The marginal propensity to consume is equal to, where tends to be change in consumption, and is the change in income. If consumption increases by 75 cents for each additional dollar of income, then MPC is equal to 0.75/1 = 0.75
Let’s suppose, on a given day an expenditure of 1000 rupees takes place and the marginal propensity to consume remain stable, the series of expenditure will take a shape of geometric progression.
∆ Stands for the increase in income.
Notice that the initial increment of expenditure Rs.1000 left a bigger effect on the income which is now Rs.4000.The multiplier is only the number by which expenditure should be multiplied so that we could see the changes in income.
From the above example if an expenditure of Rs.1000 increases, income will increase by 4000, the multiplier is 4.
From the above multiplier we have observed that the multiplier is given by the following formula:
Types of multiplier:
It refers to type of a multiplier measure by Kahn’s where the number of employment is created, activated and supplied from the base or primary jobs. let’s suppose in cosmetic products the multiplier is 1.5, means that for every job in the cosmetic products industry effects 1.5 other jobs.
Generally, this means that if employment increases by one job in cosmetic company, then 1.5 other jobs are created throughout the economy.
It’s referring to that type of multiplier where an increment of government spending tends to leave a larger impact on the national income (GDP).
The Mechanism used in this case is that an initial increment of spending by the Govt leads to increase consumption, this increment of consumption will make an income of another and hence further increase the level of expenditure that results in an overall increase in national income of the country.
- What is Money ?
- Game theory Introduction
- Circular Flow of Income
- Everything about GDP
- Aggregate demand Summary
Money Multiplier is generally the amount of money that banks generate with each dollar of reserves. Reserve is the amount of deposit that banks reserve for all the reserve that wants to reserve in the bank than to lend.
The money multiplier is the ratio of deposits to reserves in the banking system. The higher the reserve ratio, the tighter will be the money supply, which will result lesser excess reserve and would be lower multiplier effect for every dollar deposited.
The larger the money supply, the lower the reserve requirements which means more money is being generated for every dollar deposited.
An injection of investment will ultimately result many times higher increase in the income of an individual or to nation caused by that initial investment.
That is why it’s called income multiplier or investment multiplier at the same time.
The negative multiplier refers to such situation in the economy where a minor decline in investment will trigger a huge decline in the business activity.
Tax multiplier can be thought in negative or downward multiplier because if an increase in government spending leads in ever larger increase in GDP, then a contradictory case would be an increase in tax, decreasing GDP or spending.
Obviously higher taxes reduces the amount of money people used to consume and this reduction indicates less spending in the market and a leakage from the circular flow of income.
We can prove it mathematically that Tax multiplier is negative.