Multiplier Effect
What is Multiplier Effect?
The multiplier effect is the magnified change in total output and income that results from an initial change in spending.
When spending rises, it becomes income for others, who then spend a fraction of it, and the cycle repeats. The size depends on the marginal propensity to consume. It applies to changes in investment, government spending, and net exports.
Multiplier Effect: a worked example
Trace $100 million of new government spending through an economy with an MPC of 0.75. Round one puts $100 million of income in people's hands. They spend three quarters of it, so round two adds $75 million of spending and income. Round three adds 0.75 × $75 million = $56.25 million, and round four adds $42.19 million. Those first four rounds already total $273.44 million. The rounds never fully stop, but the sum converges to the initial spending times 1 ÷ (1 - 0.75) = 4, giving $100 million × 4 = $400 million of extra real GDP. The first four rounds are therefore about 68 percent of the eventual total. Lower the MPC to 0.6 and the multiplier becomes 1 ÷ 0.4 = 2.5, so the same $100 million generates only $250 million.
The mistake students make with multiplier effect
Applying the spending multiplier to a tax cut overstates the result. A dollar of government purchases enters the spending stream whole, but a dollar of tax relief lands with households first, and they save part of it, so only the MPC share gets spent in the opening round. Run the same $100 million through as a tax cut: the tax multiplier is MPC ÷ MPS = 0.75 ÷ 0.25 = 3 in size, so real GDP rises $300 million, one round short of the $400 million a purchase delivers.
Multiplier Effect questions
How do you calculate the spending multiplier?
Divide 1 by the marginal propensity to save, or equivalently 1 by (1 - MPC). An MPC of 0.8 gives a multiplier of 1 ÷ 0.2 = 5, so $20 billion of new investment eventually raises real GDP by $100 billion. Multiply the initial change in spending by the multiplier to get the total change in output, and remember the same figure applies in reverse to a spending cut.
Does the multiplier work in reverse?
Yes. A cut in spending shrinks output by the multiplier times the cut, because one person's lost spending is the next person's lost income, and that person cuts back in turn. With an MPC of 0.75 the multiplier is 4, so a $50 million drop in investment reduces real GDP by $200 million. The chain that amplifies expansions amplifies contractions just as hard.
Why is the actual multiplier smaller than the formula predicts?
Taxes, imports and rising prices drain every round of spending, and the simple formula ignores all three. Households pay tax on income they receive and spend part of the rest on imported goods, so less returns to the domestic chain than the MPC alone suggests. A rising price level absorbs part of the demand increase as well, since SRAS slopes upward. Treat 1 ÷ MPS as an upper bound rather than a prediction.
Formula / Example
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