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Multiplier Effect

  The multiplier effect is economics shorthand for the way in which a change in spending produces an even larger change in income. For example, suppose spending in an economy is increased by $100 million due to higher investment. The initial effect is to boost the incomes of those who produced the buildings or machinery that make up the extra investment. Those people will in turn spend part of their extra incomes, which puts more money into the pockets of others, who spend it … and so on.

In theory, this process could continue indefinitely, in which case the multiplier would have an infinite value. In practice, not all of the extra income is spent. Some of it leaks abroad in the form of imports, and some of it is saved rather than spent. The remainder is defined as the ‘marginal propensity to consume’ that is, that proportion of an extra dollar of income that is spent. The value of the multiplier can be derived from the simple formula of 1/(1—MPC). If 50 cents of each extra dollar is spent at home, then the multiplier has a value of 2.

The practical value of this knowledge is considerable when governments come to decide their fiscal policy. If they want to boost national income by $100 million, and they know that the multiplier is 2, they need inject only 50 million in the form of higher public expenditure or taxation cuts in order to achieve their ultimate target. This, at least, is what Keynesians argue; non-Keynesians, while accepting that spending does have a multiplier effect, argue that the notion (1) gives a misleading impression of precision and (2) implies that the extra spending will produce more real growth whereas it could all dissipate in inflation instead. TF



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