Multiplier Effect

Updated on January 30, 2024
Article byPriya Choubey
Reviewed byDheeraj Vaidya, CFA, FRM

What is Multiplier Effect?

The multiplier effect indicates how monetary injection into an economy results in a proportional increase in national income. It is a macroeconomic concept that emphasizes the role of capital investment; it creates new demand and accelerates economic activities.

In other words, it studies the impact of government spending on national demand and national income. However, the actual market condition could be the polar opposite—capital withdrawal or disinvestment can lead to decreased economic activities, decreased national demand, and reduced national income.

Key Takeaways

  • A multiplier effect is a macroeconomic tool for analyzing the impact of capital infusion. Capital infusion alters national demand and national income.
  • In other words, it is the proportionate rise or fall in the national income with respect to an addition or withdrawal of capital.
  • The fiscal multiplier is evaluated as the fraction of change in national income to the change in government spending. 
  • The Keynesian multiplier indicates that the economy grows more than the initial amount spent by the government. It is computed using the following formula:
    Multiplier = 1 / (1 – Marginal Propensity of Consumption)

Multiplier Effect Explained

The multiplier effect is a parameter used by economists and decision-makers to understand the economic impacts of increasing the money flow. Money flow has an effect on national demand, income, and other economic activities. It is derived as the number of times output increases for every increase in input. It is always favorable to get an income increase with moderate government spending.

Multiplier Effect

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Multipliers are classified into three sub-types:

  1. Fiscal Multiplier: It is one of the general multiplier effects experienced by an economy. Here, the multiplier is the fraction of the change in national income and the change in government spending.
  2. Keynesian Multiplier: The Keynesian theory suggests, that even a minute increase in government spending triggers substantial growth in the economy. As the economy flourishes, employment levels rise.
  3. Money Supply Multiplier Effect: It is useful in the banking industry. When a central bank reduces the reverse ratio requirement, commercial banks lend freely, and the supply of money escalates.

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Multiplier Effect Formula

Multipliers are computed for specific purposes, let us discuss prominent multipliers and their calculation:

Fiscal Multiplier

The basic formula for determining the multiplier effect is as follows:

Multiplier Effect Formula

or,

Formula
Keynesian Multiplier

The Keynesian multiplier gauges the consumption of the additional income; its represented by the following formula:

Formula
  • Here, M is the multiplier.
  • MPC is the Marginal Propensity of Consumption. It shows the percentage of additional income consumed in the economy.
Money Supply Multiplier Effect

The money supply multiplier effect is another important measure. The reserve ratio is a key factor behind money supply changes. It is denoted by the following formula:

Formula
  • Here, MSRM is the Money Supply Reserve Multiplier.
  • RRR is the Reserve Requirement Ratio.

Example

Now, let us take a look at a few examples to understand the practical application of multipliers.

Example #1

Let us assume that a government increases spending by $45 billion; the national income goes up by $120 billion. Now, based on given values, determine the multiplier effect.

Solution:
Given:
Change in National Income = $120 billion

Change in Government Spending = $45 billion

Multiplier Effect = Change in National Income/Change in Government Spending

Multiplier = $120 billion/$45 billion

Multiplier = 2.67

Thus, the change in government spending triggered a 2.67 times increase in the national income.

Example #2

If the consumption rate of an economy is 0.65; ascertain the multiplier effect.

Solution:
Given:
Marginal Propensity of Consumption (MPC) = 0.65

Multiplier Effect (M) = 1 / (1 – MPC)

M = 1 / (1 – 0.65)

M = 2.86

Thus, when the marginal propensity of consumption is 0.65. the Keynesian multiplier is 2.86.

Example #3

If a central bank states a reserve requirement ratio of 4.75%, find the money supply reserve multiplier.

Solution:
Given:
Reserve Requirement Ratio = 4.75% or 0.0475

Money Supply Reserve Multiplier (MSRM)  = 1 / RRR

MSRM = 1 / 0.0475 = 21.05

Thus, the money supply reserve multiplier is 21.05.

Negative Multiplier Effect

Just like scenarios where the multiplier effect is positive, it can also go the other way round. In a negative multiplier effect, the government either reduces the money injection or raises the withdrawal of money in circulation. Various reasons behind negative multipliers are as follows:

  • A slowdown in government spending.
  • Reduced consumer spending.
  • Fall in exports.
  • Reduced investments.
  • An increase in imports, savings, and taxes.

A negative multiplier can be represented using the following Keynesian multiplier formula:

M = 1 / (1 – MPC)

Even during the adverse impacts mentioned above, an economy can self-recover. The recovery can be assisted by effective monetary policies, new infusion of money, reduction in savings, increased consumer spending, boost in demand for certain commodities, and state welfare programs.

Frequently Asked Questions (FAQs)

What is the multiplier effect?

It is a macroeconomic phenomenon. The addition of new money into circulation leads to a proportional increase in national income. Thus, government spending significantly increases the nation’s gross domestic product.

How to calculate the multiplier effect?

A multiplier is evaluated as the change in national income or real GDP brought out by the change in government spending or cash infusions. If M is the multiplier, and MPC is the Marginal Propensity of Consumption, then the Keynesian multiplier is represented as follows:
‘M = 1 / (1 – MPC)’,

Also, if MSRM is the Money Supply Reserve Multiplier, and RRR is the Reserve Requirement Ratio, then the Money Supply Multiplier Effect formula is represented by the following formula:
 ‘MSRM = 1 / RRR’.

What is the role of a multiplier?

A multiplier plays a key role in identifying the impact of capital infusion on national income and national demand. A multiplier is a numerical expression for the degree of change in output—when the input is changed to a certain level.

Can the multiplier be negative?

Yes, we can get a negative multiplier when there is capital withdrawal or disinvestment. But a negative multiplier indicates the adverse condition of a nation’s real GDP.

This article is a guide to what is Multiplier Effect and its definition. We explain multiplier effect meaning, formula, & examples for Keynesian economics and macroeconomics. You can learn more about it from the following articles: –

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