In Economics, the multiplier effect is defined as the change in income to the permanent change in the flow of expenditure that caused it.
What this means is that the multiplier effect, as its name indicates, refers to the proportional amount of increase (or decrease) in final income that results from an injection (cut) of spending in the economy.
It is calculated as: Change in Income/Change in Spending, and it is used by different analysts to analyze and sometimes to forecast the effects of specific operations, usually related to new capital investments.
Even though from the classical description it may seem complex, the functioning of the multiplier is pretty simple and intuitive.
It is easier to understand with a real-life example:
Assume that a baker decides to replace his aged equipment by buying a new, bigger and more efficient oven. The new oven will allow the baker to increase the production of bread, making possible for him to increase revenue by selling more bread.
Therefore, he buys the new oven, with a total investment of $70,000. The oven works well the entire year and the baker can effectively produce and sell more bread, increasing income by $105,000.
At this point, if we calculate the multiplier effect with the formula above (Change in Income/Change in Spending), we see that the company’s multiplier is 1,5 ($105,000/$70,000 = 1,5), which means that for every $1 the baker invested, he has earned an extra $1,5.
In broader economic analysis, the effect of the multiplier is considered also outside of the effects that it can have on the income of a single company, in fact, it can also have widespread effects on the economy at large.
From this point of view, the multiplier is looked like the change in real GDP with respect to the change in government spending, private investments, taxes, interest rates, and more.
Therefore it is better to talk about injections, rather than talking solely about investments, in fact, all these injections can help the economy through the multiplier effect.
As said before, its effects are considered in the analysis of the broad economy because, the higher the multiplier, the greater the effect on the economy is. Therefore, governments will be more favorable towards investments that have a high multiplier with respect to those that have a lower or negative multiplier.
Table of Contents
Multiplier effect and money supply
When related to the money supply, the multiplier is also called the money multiplier.
The money multiplier becomes effective when it involves the reserve requirements, which is a tool of conventional monetary policy based on the rule that commercial banks must keep a certain minimum portion of their deposit liabilities as reserves, either in its vaults or at the central bank.
This means that, when a company or an individual deposits cash into his bank account, the bank can lend that money as soon as it keeps a required portion as a reserve.
So suppose that the reserve ratio is 20%, and the baker of the previous example, after one year of activity, decides to deposit $100.000 into his bank account. At this point, the bank can lend that amount of money minus the reserves, say $20,000 (20%) to John, an electrician who wants to buy a small warehouse for $80,000.
At this point, Sarah, the seller of the warehouse, will take the money that she earned from the sale, and will deposit it into her bank account. That sum of money will be available to the bank for new lending, creating, therefore a circle.
The interesting factor is that, during this process, even though the original depositor (the baker) maintains ownership of his initial deposit, the steps that took place after that, “created” new money in the economy.
In this case, the entity of multiplier effect is strictly linked to the entity of the required reserves, in fact, lowering the portion required allows banks to loan more money to businesses and consumers, therefore the multiplier effect would be higher, and more money will be created.
On the contrary, if the central bank wants to “slow down” the economy, and decrease the money supply, a higher portion required as minimum reserve ratio, slows down the multiplier effect, reducing the amount of money available to commercial banks for their lending activities, limiting their ability to expand credit.
The graphical representation of the multiplier effect is the following. We see that the new injection, due for example to an increase in government spending, has an effect on the Aggregate Demand (AD) curve, and makes it shift on the right, from AD to AD’.
Then, with the effect of the multiplier, the AD curve shifts again from AD’ to AD’’.