The Multiplier Effect

The Multiplier

Key Terms

Accelerator: The accelerator effect is defined as the effect positive market economic growth has on private fixed income, for example, through changes in real output.

Multiplier: A ratio used to estimate total economic effect for a variety of economic activities.

Average Propensity to Consume: Refers to the percentage (proportion) of income the households dedicate to consumer expenditure. This can be used to analyse the consumption function.

Marginal Propensity to Consume (MPC): Is a metric that quantifies induced consumption, the concept that the increase in personal consumer spending (consumption) occurs with an increase in disposable income (income after taxes and transfers).

Marginal Propensity to Save (MPS): Is the fraction of an increase in income that is not spent and instead used for saving. It is the slope of the line plotting saving against income.

Marginal Propensity to Import (MPM): Is the fractional change in import expenditure that occurs with a change in disposable income (income after taxes and transfers).

Marginal Propensity to Tax (MPT): The amount of additional income that is taxed.

Marginal Propensity to Withdraw (MPW): Save plus import plus tax is the MPW. The amount of income that is withdrawn from the circular flow of income.

The National Income Multiplier

The concept of the multiplier was formally introduced by economist John Maynard Keynes in his “The General Theory of Employment, Interest, and Money" in 1936. Keynes highlighted that there might be some form of ‘multiplier effect’ taking place in response to certain expenditures. For example, if a government invests 100 million in the creation of a hospital, the contractors who take this job in turn pay their workers/suppliers etc... let’s take the workers perspectives now, they have just received their wages and now have a choice to save a certain proportion of it and spend the other portion, which in turn goes to the café/shop/restaurant owners etc… and the cycle repeats until it diminishes. As can be seen from this example one initial investment causes multiple streams of income for different parties as the money is spent over and over again essentially ‘multiplying’ the initial investment.

(The example above can be seen demonstrated in this diagram)

However, one must notice that only the act of spending allows the multiplier effect to take place. If households who receive additional income, chose not to spend some of this income the effects are diluted. You could also view it in terms of the circular flow of income, where injections trigger the multiplier effect however, only leakages determine the size of the effect.

The size of the multiplier effect depends on how much of the additional income is:

Saved by Households
Spent on Imported Goods
Returned to the Government in the Form of Direct Tax

The higher the number are for these leakages the lower the multiplier effect, because if a household saves most of its additional income, it will reduce the multiplier effect as the next round of spending will be smaller.

Average and Marginal Propensity to Consume

The average propensity to consume (and marginal propensity to consume) is a concept also developed by John Maynard Keynes to analyse the consumption function. Keynes talks about five main elements:

Marginal Propensity to Consume (MPC),
Marginal Propensity to Save (MPS),
Marginal Propensity to Withdraw (MPW),
Marginal Propensity to Tax (MPT)
Marginal Propensity to Import (MPM)

We can use these elements to calculate the size of the multiplier effect. We also need to keep in mind that the multiplier effect is triggered by injections such as government spending, investments, and exports whilst the size is determined by the leakages; imports, saving and tax.

The marginal propensity to consume is essentially in a nutshell the tendency to use any of the additional income in the purchase of goods/services hence consumer expenditure. Whilst the marginal propensity to save is the amount of the additional income that is saved by households. As mentioned earlier we also need to consider the leakages which we can see as the marginal propensity to tax (the proportion of additional income taxed) and the marginal propensity to import (the amount spent on imports from the additional income), as well as marginal propensity to save.

In order for us to work out the size of the multiplier we must however workout the total size of the leakages, the total size of the leakages is known as the marginal propensity to withdraw (MPW) and can be worked out by adding all leakages together:

MPW = MPS + MPT + MPM

This now shows us the marginal propensity to withdraw (total size of leakages) however in order for us to work out the marginal propensity to consume we have to do the following equation:

MPC = 1 – MPW

The marginal propensity to consume now essentially tells us how strong the multiplier effect will be.

The Multiplier in Terms of AD/AS Diagram

The multiplier effect can be seen in an aggregate demand/supply graph. I there is an increase in a injection, as we know that causes the aggregate demand curve to shift to the right (ADo-->AD1) however due to the multiplier aggregate demand shifts to the right again (AD2) as can be seen in the diagram below:

The Multiplier Last Words

The multiplier affects the extent to which the aggregate demand curve shifts when there is increase in autonomous spending, however this doesn’t necessarily cause a change in the macroeconomic equilibrium in the long run. It all depends on the position of the aggregate demand prior to the shift, if the demand curve is in the vertical part of the aggregate supply, then its shift would cause a sole increase in price level rather than output. Whilst if the demand curve is in the upward-sloping part of the supply curve, its increase would increase output and bring the economy closer to full employment. This is important to keep in mind as governments need to take this into consideration when planning an increase in spending to ensure that they don’t create 'pure' inflation.

However, neither of these changes affect the equilibrium in the long run, as the aggregate supply shifts and a new equilibrium is established diluting the effects of the multiplier.

(In the graph above we can see the initial injection shifting the aggregate demand curve from AD0 to AD1 which is here the government ideally wanted the economy to (at full employment) however the multiplier effect has not been taking into consideration, and we can see its effect kick in and further shifting the aggregate demand curve to AD2 not actually creating any extra output but increasing price level (inflation))

(In the above scenario, we can see that the government has taken into account the multiplier effect and only invested enough money to shift the aggregate demand curve from AD0 to AD1, from which the multiplier effect kicked in bringing the aggregate demand curve to full employment.)

Sources/Further Reading:

Marginal propensity to save – Wikipedia - https://en.wikipedia.org/wiki/Marginal_propensity_to_save

The General Theory of Employment, Interest and Money – John Maynard Keynes

Marginal propensity to import – Wikipedia - https://en.wikipedia.org/wiki/Marginal_propensity_to_import#:~:text=The%20marginal%20propensity%20to%20import,income%20after%20taxes%20and%20transfers).

Marginal Propensity to Consume - Wikipedia - https://en.wikipedia.org/wiki/Marginal_propensity_to_consume

Multiplier – Wikipedia - https://en.wikipedia.org/wiki/Multiplier_(economics)

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