Why is the multiplier greater than 1
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
