“New Expenditure” has far-reaching effects on aggregate levels of income since “one man’s spending is another man’s income”. The Keynesian Theory of ” The The Multiplier Effect explains this.
- Small changes in the Marginal Propensity have dramatic effects on the size of the multiplier.
- The Multiplier effect is always >1 unless MPC = 0
- The Multiplier Effect applies to any autonomous change in expenditure (G1 Government spending, investment, exports)
Example Economy
has three sectors, households, firms, and the financial sector.
- Industry employees more people
- Now employed households spend part of their income on goods & services including food, clothing, rent and entertainment.
- This flows throughout the entire Circular Flow Of Income.
Multiplier
This flow of income throughout the economy is what we refer to as the multiplier.
e.g. increase in investment of
| Time Period | Y = | C + | S |
|---|---|---|---|
| 1 (Initial Investment) | 10 | 6 | +4.00 |
| 2 | 6 | 3.60 | 2.40 |
| 3 | 3.60 | 2.16 | 1.44 |
| 4 | 2.16 | 1.30 | 0.86 |
| Sum of periods | |||
| After |
To find the multiplier we can take the total amount of income generated by the
investment (After
Methods of calculating the Multiplier (k)
Method 1
Method 2 (and 2.5)
If you do not have the end result, you can also use the MPS [!question]
- The multiplier effect shows the effect of one persions spending on another’s income.
- An initial investment $10b creates new income
- Income that is spent creates new income for others in the following time period.
- Follow-on income is partially saved, those spent produuces even more income in the following time period.
What if MPC increases?
An increase in Marginal Propensity to consume causes a reater “respending effect”.
basically; the multiplier from a given investment would be higher the more we consume.
e.g.
- Small changes in the Marginal Propensity have dramatic effects on the size of the multiplier.
- The Multiplier effect is always >1 unless MPC = 0
- Marginal Propensity changes as a result of attitudes to spending and saving. It may change over time.
- The MPC is an average across all households in the economy
Multiplier causes equilibrium income to increase greatly
- At Equilibrium Savings & Investment are equal (60)
- An increase in investment of 10 lifts up investment to point
( ) function lifts up by as well, making it . - Since the
function increases by equilibrium income moves right 
This diagram depicts the new equilibrium income, it will get there through “steps” towards equilibrium, each step to the right (increase in income) will come from a segment of the previous step’s induced income according to the MPC, e.g. Initially 6, then $3.6 and so on. This can be seen in the diagram below 
ceteris paribus it will aproach the new equilibrium income with every step.
Book Examples
The Multiplier process applies to any autonomous change in expenditure - which could be a change in investment, govenrment spending or exports. Examples include:
- Resource projects in the Pilbara region of WA;
- Government spending on new railways; or
- the increase in the Jobseker allowance during the pandemic
It also applies to decreases in Autonomous spending like;
- Closure of a bank in a rural town
These would all have a ripple effect on other services. e.g. for the closure of a local bank, bank employees move, causing supermarket turnover, cafe sales, doctors visits, etcetera, all to fall. On A larger scale;
- The Global Financial Crisis (2008-09)
- Pandemic (2020)
both cause a fall in investment spending and a fall in GDP which would induce the multiplier negatively.
Other factors that influence Multiplier effect
- The Multiplier would equal infinity if the MPC was equal to one. The multiplier is restricted by the size of leakages from;
- Savings
- Taxation
- Imports
Each of these leakages reduces the size of the multiplier.
The multiplier equation taking into account leakages is this;
Where: = Marginal Propensity to save = Marginal Propensity to tax = Marginal Propensity to import e.g.
The Multiplier in the Australian economy is on average between 1.5 and 2.5#econs-example
References