3.2 — The Multiplier Effect

The multiplier effect refers to the phenomenon that an investment or tax by the government will have a significantly larger impact on the economy than the investment or tax itself. This is explained further in 3.8 — Fiscal Policy and 3.9 — Automatic Stabilizers.

Spending Multiplier

When the government spends money, it becomes someone’s income which they save a fraction of while spending the rest, and this becomes another person’s income. This happens repeatedly and is known as the multiplier effect. This causes a ripple effect in the economy and increases the total spending.

To determine how much people save/spend:

• Marginal Propensity to Consume (MPC): The proportion of your income which you continue to spend
• Marginal Propensity to Save (MPS): The proportion of your income which you save

$MPC+MPS=1$ The simple spending multiplier is equal to the reciprocal of the MPS: $\text{Simple Spending Multipler}=\frac{1}{MPS}$

Thus, if the government increases investment by $2billiondollars,thetotalspendingwillincreaseby$4 billion dollars if the Simple Spending Multiplier is 2.

Tax Multiplier

The tax multiplier shows what happens when the government cuts taxes, but its not as strong as the spending multiplier. $\text{Tax Multiplier}=-\frac{MPC}{MPS}$ We don’t need to know this formula, but rather always assume that the tax multiplier is always 1 less than the spending multiplier.

Money Multiplier

When we deposit money in the bank, it must reserve a fraction of the money before loaning it out. This happens over and over again. This mandated portion of the bank’s assets that must be held in reserve is known as the reserve requirement. From this, we can extract the following formula: $\text{Money Multiplier}=\frac{1}{\text{Reserve Requirement}}$ For example, if the reserve requirement is 1, then the money multiplier is 10.