the

The Multiplier Effect (In less than 5 minutes)

the multiplier is a key economic concept

to understand economic growth and how

government policy affects the overall

economy through market forces now the

multiplier process is an economic

concept developed by famous economist

John Maynard Keynes but before we get

into the multiplier let's rewind back to

look at a simplified version of the

circular flow of income model in an

economy where there are only households

businesses and financial institutions

there is a continuous flow of income

circulating through the economy

financial institutions lend money to

businesses for investment purposes the

businesses grow and require individuals

to work for them as employees for which

they then pay them with income as a

reward individuals then choose to either

save or spend their income the

proportion that is saved goes back to

financial institutions who will use the

money to lend to other businesses and

the proportion of income that

individuals consume will be spent on

goods and services sold by businesses

and the cycle continues things like

investment and spending are called

injections into the economy because they

increase aggregate income and boost

economic growth savings on the other

hand is known as a linkage because it

takes money out of the circular flow of

income and reduces the level of economic

activity okay now let's go back to the

multiplier the multiplier can be defined

as the greater than proportional

increase in national income resulting

from an increase in aggregate demand but

what does this actually mean it means

that when there is economic activity

that changes injections and leakages

into the economy the initial increase or

decrease in injections and leakages will

have a multiplier effect on national

income and let's look at why this

happens so let's say a decrease in

interest rates will lead to businesses

borrowing more money for investment

purposes and an increase in business

spending more business investment will

make them employ more people providing

households with more disposable income

with this new income they will either

spend it or save it the part they

consumed with will lead to further

business revenue investment and so the

cycle continues

so the initial increase in business

investment gets multiplied through the

increase in household income and

consumption and the circular flow of

income cycle but how big the multiplied

effect will be depends on the marginal

propensity to consume of individuals now

marginal propensity to consume is the

proportion of each extra dollar of

income that is spent on consumer

products in other words changing and

spending that results from a change in

your income additionally your marginal

propensity to save is the proportion of

each extra dollar of income that you

save so it's the change in saving that

results from a change in income so if

for every extra dollar of income and

individual receives they spend 80 cents

then their marginal propensity to

consume is 0.8 and the MPs is 0.2 now

remember marginal propensity to consume

and marginal propensity to save always

add to 1 now to calculate the multiplier

K we use the formula 1 over 1 minus MPC

or 1 over MPs so let's look at a basic

example the government increases

spending by 10 billion dollars what will

be the multiplier and its effect on the

economy if individuals MPC is 0.6 now

there's 2 steps to solve this problem

the first is to use the multiplier

equation to find the value of the

multiplier okay and once you've done

this you then multiply the initial

injection of government spending into

the economy by the multiplier so this is

the ten billion dollars times two point

five which equals 25 billion dollars and

what this means overall is that the

initial government spending of ten

billion dollars has passed through the

circular flow of income model we looked

at earlier and through this process

it's multiplied and the final effect it

has on the economy is worth twenty five

billion dollars and so that's the

multiplier in a nutshell