The multiplier effect occurs when an initial change in aggregate demand, such as an increase in government spending, leads to a multiplied impact on real GDP through subsequent rounds of re-spending. The multiplier effect arises because the initial spending increases household incomes and business revenues, which are then spent again on new output, generating further income and demand. This multiplier process can continue, amplified at each round, resulting in an eventual increase in real GDP that is multiple times the size of the initial change in spending. The size of the multiplier depends on factors like the marginal propensity to consume, save, tax and import.

1. The Multiplier Effect / Multiplier Process
A change in one of the components of aggregate demand can lead
to a multiplied final change in the level of GDP

2. The Multiplier Effect / Multiplier Process
A change in one of the components of aggregate demand can lead
to a multiplied final change in the level of GDP
The multiplier effect comes about because injections of new
demand for goods and services into the circular flow of income
stimulate further rounds of spending – in other words “one
person’s spending is another’s income”
This can lead to a bigger eventual effect on output and
employment

3. An Example of the Multiplier Effect
The government injects
£200m in a project to build
thousands of new houses
Why is the final increase in
measured GDP likely to be
more than £200m?
If the final rise in GDP is £300m the value of the multiplier = 1.5
If the final rise in GDP is £250m the value of the multiplier = 1.25

4. An Example of the Multiplier Effect
New build housing project injects £200m of new
output into the economy
Many businesses / sectors benefit directly – list four
examples
The government injects
£200m in a project to build
thousands of new houses
Building new houses generates a new flow of factor
incomes – including wages and profits
Will the extra income stay inside the circular flow of
income and spending?
If so, the multiplier effect is likely to be strong

5. An Example of the Multiplier Effect
New build housing project injects £200m of new
output into the economy
Many businesses / sectors benefit directly – list four
examples
The government injects
£200m in a project to build
thousands of new houses
Building new houses generates a new flow of factor
incomes – including wages and profits
Will the extra income stay inside the circular flow of
income and spending?
If so, the multiplier effect is likely to be strong

6. An Example of the Multiplier Effect
New build housing project injects £200m of new
output into the economy
Many businesses / sectors benefit directly – list four
examples
The government injects
£200m in a project to build
thousands of new houses
Building new houses generates a new flow of factor
incomes – including wages and profits
Will the extra income stay inside the circular flow of
income and spending?
If so, the multiplier effect is likely to be strong

7. An Example of the Multiplier Effect
New build housing project injects £200m of new
output into the economy
Many businesses / sectors benefit directly – list four
examples
The government injects
£200m in a project to build
thousands of new houses
Building new houses generates a new flow of factor
incomes – including wages and profits
Will the extra income stay inside the circular flow of
income and spending?
If so, the multiplier effect is likely to be strong

8. An Example of the Multiplier Effect
New build housing project injects £200m of new
output into the economy
Many businesses / sectors benefit directly – list four
examples
The government injects
£200m in a project to build
thousands of new houses
Building new houses generates a new flow of factor
incomes – including wages and profits
Will the extra income stay inside the circular flow of
income and spending?
If so, the multiplier effect is likely to be strong

9. An Example of the Multiplier Effect
The rate of leakage from the circular flow
Assume that for each £100 pound of extra
income generated
• 10% is saved
• 20% is taken in taxation
• 20% leaks from the economy in imports
The government injects
£200m in a project to build
thousands of new houses
• The rate of leakage from the circular flow is
vital to understanding the size of the
multiplier effect

10. An Example of the Multiplier Effect
• £20m saved
• £40m taxed
• £40m imports
£200m
Injection
£100m extra
GDP
• £10m saved
• £20m taxed
• £20 imports
• £Xm saved
• £Xm taxed
• £Xm imports
£50m extra
GDP
At each stage the extra money
flowing around the circular
flow gets smaller

11. An Example of the Multiplier Effect
The formal calculation for the value of the multiplier is
Multiplier = 1 / (sum of the propensity to save + tax + import)

12. An Example of the Multiplier Effect
Multiplier = 1 / (sum of the propensity to save + tax + import)
If propensity to save = 0.1
Propensity to tax = 0.2
Propensity to import = 0.2
Then the multiplier = 1/0.5 = 2

13. An Example of the Multiplier Effect
Multiplier = 1 / (sum of the propensity to save + tax + import)
If propensity to save = 0.2
Propensity to tax = 0.3
Propensity to import = 0.3
Then the multiplier = 1/0.8 = 1.25

14. An Example of the Multiplier Effect
When the rate of leakage
from the circular flow is
high ………. The value of
the multiplier effect will
be small
Multiplier = 1 / (sum of the propensity to save + tax + import)
If propensity to save = 0.2
Propensity to tax = 0.3
Propensity to import = 0.3
Then the multiplier = 1/0.8 = 1.25

15. Key Factors Affecting the Value of the Multiplier
Propensity
to import
Avoiding
crowding
out effects
Amount of
spare
capacity
The value
of the
multiplier
Propensity
to save
Propensity
to tax

16. The IMF on the Fiscal Multiplier
Government investment—things like infrastructure building—results in higher
multipliers. Economists at the IMF have calculated the long-run multiplier at 1.5 for
developed countries and 1.6 for developing countries. In other words, developing
countries really benefit from government investment over government
consumption. Investment can build the productive capacity of the economy,
resulting in beneficial long-term effects.
Many governments have been introducing fiscal austerity policies – cutting
spending and lifting taxes in a bid to lower their budget deficits. The fiscal multiplier
effect is important here too. If the multiplier is 0.5, then an initial government
expenditure reduction of 1 per cent of GDP reduces real output by 0.5 per cent. If,
however, the multiplier is 1.7, then the same initial public spending cut of 1 per
cent of GDP would reduce real output by 1.7 per cent. The big danger of a high
fiscal multiplier is that a period of deep cuts in state spending will cause an even
larger drop in GDP which in turn will increase the size of the budget deficit. Fiscal
austerity can turn out to be self-defeating.
One problem is that the actual value of the multiplier effect is likely to change at
different points of the economic cycle.
(Source: Adapted from the Economist and other news reports, July 2013)

17. The Multiplier Effect in the News

18. What are the main objectives of macroeconomic policies?
Price Stability – Low
Positive Inflation
Sustainable Growth of
Real GDP
Improved
Competitiveness / Trade
Falling Unemployment
Sound Government
Finances
Higher Average Living
Standards
Equitable Distribution of
Income and Wealth

19. AS Macro Course Support
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