The multiplier effect is essentially the idea that spending in an economy ripples through.
Money is re-spent as it changes hands, such that each $1 spent has an outsized impact. That is: total expenditure produced by $1 spent today is ultimately greater than the initial $1.
For instance, if you earn $100 and spend $90 in a local food store (expensive shop), the owner now has $90 to spend. He might then spend $81 of this expanding his business (small expansion). The contractors he paid to complete the job now have $81. They may spend on clothes. The employees of the clothing store may then spend some of their money on paper umbrellas to replace their waterproof devices (questionable choice) …
- etc - etc - and so on - and so forth.
Point is: parts of the initial $100 were recirculated, and so the ultimate spending produced by giving you that $100 was greater than the $100.
Since money is assumed respent: additions to circulation will, in theory at least, produce effects larger than the initial injection.
Similarly, removals from circulation will produce effects larger than the initial withdrawal since the money removed will now no longer circulate over and over again.
Thinking back to the withdrawals enumerated on the very basic circular flow diagram:
If the $90 you decided to spend on food was: taxed away, spent on imports, or saved, the shopkeeper may not have spent on his extension; the contractors would not have been paid; and, the clothing-store employees may have remained dry during last week’s rains.
Potential spending is foregone: one might attach an opportunity cost to withdrawals.
Take an introductory economics class and you’ll come across the following formula for the multiplier:
Where:
MPC represents the marginal propensity to consume (the proportion of a change in income which is spent on consumption)
MPW represents the marginal propensity to withdraw (the proportion of a change in income which is not spent on consumption / is removed from circulation)
-removals usually taught to come in the form of: saving, taxation, spending on imports since each takes money out of domestic circulation
A multiplier of 2 means that $1 of spending today should ultimately produce $2 of spending
NOTE: The formula comes from the infinite sum of geometric series
The concept of a spending multplier is not without problems:
-measurement: tricky to actually quantify
-time lag: between spending and possible economy-boosting effect
-reality: the rate of circulation is unlikely to be constant: this presents problems for the formula derived from that for the sum to infinity of a geometric series, which assumes a constant common ratio (here the MPC)
Faith in the multiplier informs arguments against austerity measures during recession.
something to the effect of:
Budget-cuts & or tax hikes are liable to reduce spending, presenting an opportunity cost in the form of money that might otherwise have circulated many times.
The spending foregone could have stimulated economic growth.
Austerity may lead to slower recovery.