John Maynard Keynes, the founder of Keynesian economics and the father of modern macroeconomics, introduced the idea of Multiplier Effect in his seminal work ‘The General Theory of Employment, Interest, and Money’ published in 1936.
The Multiplier Effect theory became a cornerstone of Keynesian economics and has had a significant impact on modern macroeconomic policies.
What is Multiplier Effect?
Multiplier Effect states that national income will increase by an amount greater than the value of the injection itself multiplying the benefits for the country.
For example, if investment is made into the economy by the government to build a new highway, many jobs are created. New jobs will lead to more people earning money and they will spend that money on further goods and services. Simply, the demand will drive the supply.
Specifically, people will spend money on food, clothes, electronics, cars, holidays, etc. These industries would be experiencing higher demand, so they would employ more people who spend more money in the economy.
Again, this increases Aggregate Demand (AD), so the cycle continues. It is like a snowball rolling downhill, picking up more snow and growing larger as it goes.
How does Multiplier Effect work?
Here is how it works:
- Initial Injection: Imagine the government decides to invest in a new infrastructure project, like building a bridge. This initial spending is an injection into the economy.
- Income Generation: The construction company hires workers and buys materials, which creates income for these individuals and businesses.
- Increased Spending: The workers and businesses now have more money to spend. They may use it to buy groceries, pay rent, or purchase new goods and services.
- Further Income Generation: The businesses that receive this increased spending also earn more income, which they can then use to pay employees, buy supplies, or expand their operations.
- Cycle Repeats: This process continues, with each round of spending generating additional income and further stimulating economic activity.
Key points to consider:
MULTIPLIER: The multiplier is the factor by which the initial injection is magnified. It’s calculated as 1/(1-MPC), where MPC is the marginal propensity to consume (the proportion of additional income that is spent).
FACTORS AFFECTING THE MULTIPLIER: The size of the multiplier depends on factors like the marginal propensity to consume, the marginal propensity to save, and the level of TAXation.
POLICY IMPLICATIONS: Governments can use the multiplier effect to stimulate economic growth during recessions by increasing government spending or cutting taxes. However, it is important to consider potential side effects like inflation and debt accumulation.
In essence, the multiplier effect demonstrates how a relatively small initial investment can have a significant impact on the overall economy, making it a valuable tool for policymakers and economists alike.
