The multiplier effect explains how an initial change in spending leads to a larger overall change in national income, influencing economic growth and policy decisions.
What is the multiplier?
The multiplier is a concept used in macroeconomics to describe the proportional relationship between an initial change in spending (an injection into the circular flow of income) and the resulting change in national income. This process reflects how money circulates through the economy, where one person's spending becomes another person's income. When an injection such as government spending, investment, or export revenue enters the economy, it can create a ripple effect that magnifies the initial impact on aggregate demand (AD) and total economic output.
For example, if the government invests £200 million in building a new hospital, the construction workers and suppliers involved receive income. They then spend part of that income on goods and services, supporting other businesses and workers in the economy. These people, in turn, spend a portion of their income, further stimulating economic activity. Though the effect weakens with each round of spending due to withdrawals (like savings or taxes), the overall increase in national income exceeds the initial £200 million.
The multiplier therefore shows how interconnected the economy is and highlights how economic activity can be stimulated or suppressed by initial changes in spending behaviour.
The multiplier ratio
The multiplier ratio represents the degree to which an initial change in aggregate demand will affect the total level of national income. It quantifies the multiplier effect and is calculated using a simple formula:
Multiplier = total change in national income ÷ initial change in spending
For example, if a £100 million rise in government spending results in a £300 million increase in national income, the multiplier is 3.
This means that for every £1 initially injected into the economy, total output and income increase by £3. The value of the multiplier depends on how much of the additional income is spent domestically and how much is withdrawn from the circular flow through savings, taxes, or imports.
How the multiplier process works
The multiplier process begins when there is an injection into the circular flow of income, such as:
Government spending
Private investment
Export revenue
This injection raises the income of those directly involved in the economic activity, such as workers, firms, and suppliers. These recipients then spend part of their increased income, which becomes income for others in the economy. This process continues in several rounds, although the size of each round diminishes due to withdrawals.
Example of the multiplier process:
Government spends £100 million on infrastructure projects.
Construction companies pay workers and buy materials.
Workers use part of their wages to buy goods and services.
Retailers and service providers see increased demand and hire more staff or invest in expansion.
These new workers spend part of their income, repeating the cycle.
This chain reaction of spending continues until the economy reaches a new level of national income. Each round of spending gets smaller because part of the income is saved, taxed, or spent on imports.
Economic effects of the multiplier
The multiplier can have a powerful amplifying effect on the economy. Depending on the direction of the initial change in spending, it can:
Stimulate economic growth: When there is an increase in investment, government spending, or exports, the multiplier effect leads to a larger increase in output, employment, and income.
Deepen economic downturns: Conversely, a reduction in aggregate demand (e.g., spending cuts, higher taxes, reduced investment) results in a multiplied decline in national income, potentially leading to recession and unemployment.
This dynamic means that relatively small policy changes can have significant macroeconomic consequences, either boosting or contracting the economy depending on how they interact with the multiplier.
Marginal propensities and their role
The size of the multiplier depends on how much of additional income is spent versus how much is withdrawn from the economy. This is determined by the marginal propensities, which describe how individuals allocate any extra income they receive.
Marginal propensity to consume (MPC)
The MPC is the fraction of any extra income that is spent on consumption.
For example, if someone receives an extra £1 and spends 80p, the MPC is 0.8.
A higher MPC means more income is recirculated in the economy, resulting in a larger multiplier.
Marginal propensity to save (MPS)
The MPS is the fraction of extra income that is saved rather than spent.
If 20p of an extra £1 is saved, the MPS is 0.2.
A higher MPS leads to a smaller multiplier, since more income is removed from circulation.
Marginal propensity to tax (MPT)
The MPT is the fraction of additional income paid to the government in taxes.
If 15p of every £1 is taxed, the MPT is 0.15.
Higher taxation reduces the size of the multiplier, as it decreases consumers’ disposable income.
Marginal propensity to import (MPM)
The MPM is the fraction of additional income spent on imported goods and services.
If consumers spend 25p of every additional £1 on imports, the MPM is 0.25.
This spending leaks out of the domestic economy, lowering the multiplier.
The more income is withdrawn, the smaller the effect of the multiplier. Together, the MPS, MPT, and MPM form the marginal propensity to withdraw (MPW), which plays a central role in determining the multiplier.
Impact of propensities on multiplier size
To determine the exact size of the multiplier, we need to understand how these marginal propensities combine.
A higher MPC (and thus lower MPW) means more income is re-spent in the economy, increasing the total effect on national income. On the other hand, higher withdrawals via saving, taxes, or imports reduce the effect of any initial injection.
The inverse of the MPW gives us the multiplier value:
Multiplier = 1 ÷ MPW
Where:
MPW = MPS + MPT + MPM
This formula shows that if withdrawals are high, the multiplier will be small, and fiscal policy will be less effective in influencing national income.
Multiplier formulae
For a simplified (closed) economy
In a simplified model with no government or international trade, the only withdrawal is saving. The formula becomes:
Multiplier = 1 ÷ (1 – MPC)
This is because:
1 – MPC = MPS
Example:
If MPC = 0.75
Multiplier = 1 ÷ (1 – 0.75) = 1 ÷ 0.25 = 4
This means a £1 million increase in spending would increase national income by £4 million.
For an open economy with government and trade
In a more realistic economy with saving, taxation, and imports, we use:
Multiplier = 1 ÷ (MPS + MPT + MPM)
This is written as:
Multiplier = 1 ÷ MPW
Example:
MPS = 0.1, MPT = 0.2, MPM = 0.2
MPW = 0.5
Multiplier = 1 ÷ 0.5 = 2
A £50 million rise in government spending would raise national income by £100 million.
Numerical applications of the multiplier
Example 1: Simplified closed economy
Government increases investment by £40 million
MPC = 0.8 → MPS = 0.2
Multiplier = 1 ÷ 0.2 = 5
Change in national income = 40 × 5 = £200 million
Example 2: Open economy
Government increases spending by £100 million
MPS = 0.15, MPT = 0.1, MPM = 0.2 → MPW = 0.45
Multiplier = 1 ÷ 0.45 ≈ 2.22
Total increase in national income = 100 × 2.22 = £222 million
These examples highlight how a smaller MPW leads to a larger total change in income, while a higher MPW restricts the impact of injections.
The multiplier and macroeconomic policy
The multiplier has important implications for fiscal policy. Policymakers can use it to estimate the effectiveness of government spending or tax changes.
If the multiplier is large, then small increases in government spending or tax cuts can have a significant impact on economic growth and employment.
During periods of low demand, using fiscal stimulus in the form of increased spending can kick-start the multiplier process, boosting output and reducing unemployment.
However, if the economy is already near full capacity, the extra demand may only increase inflation rather than output.
For example, a £10 billion infrastructure project with a multiplier of 2.5 would increase national income by £25 billion, potentially helping to close an output gap during a recession.
Fiscal stimulus and overheating risk
If the multiplier is overestimated, excessive government spending can lead to overheating, where the increase in demand exceeds the economy’s capacity to supply goods and services. This results in inflationary pressure rather than real growth.
Governments must therefore use the multiplier cautiously, balancing the need for stimulus with the risks of inflation and unsustainable debt.
Limitations of the multiplier effect
Despite its theoretical appeal, the multiplier has several practical limitations:
Time lags
It takes time for government policies to feed through to income and spending.
The full impact of the multiplier may only be seen after several quarters or years.
Crowding out
If government borrowing rises to finance spending, it may increase interest rates.
This could discourage private sector investment, reducing the effectiveness of fiscal stimulus.
Leakages
In open economies, much of the increase in demand might be spent on imports, reducing the domestic impact.
High tax rates and saving levels also drain money from the spending cycle.
Capacity constraints
If the economy is near full employment, increased demand may push up prices rather than output.
In such cases, the multiplier effect is limited, and inflation becomes a concern.
These limitations mean that although the multiplier is useful for understanding the potential impact of spending changes, real-world outcomes depend on the context, timing, and structure of the economy.
FAQ
Yes, the multiplier can be less than one if the marginal propensity to withdraw (MPW) is very high. This occurs when most of any additional income is saved, taxed, or spent on imports rather than being re-spent domestically. For example, if the marginal propensities to save, tax, and import are all high, the overall level of domestic spending in each round of the multiplier process will be very low. When the multiplier is less than one, any injection into the economy results in a smaller increase in national income than the original amount spent. In other words, the economy experiences a dampened effect from government or private sector spending. This scenario often occurs in highly open economies with high saving rates or restrictive fiscal policies. It suggests that fiscal interventions may have limited effectiveness, and additional measures might be needed to boost demand, such as tax incentives or policies aimed at increasing consumer confidence and reducing leakages.
Consumer confidence plays a critical role in shaping the size and effectiveness of the multiplier. When confidence is high, households are more likely to spend a greater proportion of any additional income they receive, leading to a higher marginal propensity to consume (MPC). This increases the size of the multiplier because more money circulates through the economy with each round of spending. In contrast, when consumer confidence is low, households may choose to save more or pay off debts instead of spending. This raises the marginal propensity to save (MPS) and thus increases the marginal propensity to withdraw (MPW), reducing the multiplier effect. A low-confidence environment can weaken the impact of government stimulus, as the initial injection fails to generate much additional economic activity. Therefore, improving consumer confidence can be just as important as increasing spending itself when trying to stimulate the economy. Confidence can be influenced by job security, inflation expectations, and political stability.
In real-world economies, the actual multiplier is often smaller than the theoretical value due to several practical limitations. Firstly, time lags in consumer and business responses to income changes can delay or reduce the cumulative rounds of spending assumed in theory. Secondly, supply-side constraints such as limited productive capacity, labour shortages, or infrastructure bottlenecks can limit how much output can increase in response to greater demand, thereby capping the multiplier. Thirdly, expectations and behavioural factors, like uncertainty or fear of inflation, might cause consumers or firms to behave differently than predicted by models. Additionally, globalisation means that a significant portion of increased demand may be met by imports rather than domestic output, especially in open economies, reducing the domestic impact of spending. Government inefficiencies or administrative delays in implementing spending programmes can also reduce the effectiveness of injections. These real-world factors all contribute to the difference between calculated multipliers and observed economic outcomes.
While not covered explicitly in the basic explanation of the multiplier, automatic stabilisers play a background role in moderating the multiplier’s effects. Automatic stabilisers include mechanisms like progressive taxation and welfare payments that adjust automatically with changes in the economic cycle. When the economy grows, higher incomes lead to increased tax payments and reduced welfare outlays, which act as leakages from the circular flow. This naturally reduces the marginal propensity to consume (MPC) and increases the marginal propensity to withdraw (MPW), lowering the multiplier during booms. In downturns, falling incomes reduce tax revenues and increase welfare benefits, supporting disposable incomes and consumption, thereby reducing the fall in national income. This moderating influence means that automatic stabilisers help smooth out fluctuations in economic output. While they can slightly weaken the multiplier effect in periods of expansion, they also help prevent sharp contractions by sustaining aggregate demand in recessions without the need for new fiscal interventions.
The multiplier effect can vary depending on whether the government or private sector is engaging in capital investment or current spending. Capital investment refers to spending on long-term assets such as infrastructure, equipment, and technology, while current spending includes wages, benefits, and operational costs. Capital investment typically has a larger and more sustained multiplier effect over time. This is because it not only generates immediate income through construction and production but also increases the productive capacity of the economy, leading to future rounds of output and income. For example, building a new rail line boosts employment and spending now and improves transport efficiency for decades, supporting higher future productivity and income. On the other hand, current spending, such as increasing public sector wages, has a more immediate but short-lived effect. It boosts consumption quickly, especially if recipients have a high MPC, but it does not necessarily enhance long-term economic capacity. Policymakers must therefore balance short-term demand stimulus with long-term supply-side improvements when designing spending programmes.
Practice Questions
Explain how the size of the marginal propensity to withdraw (MPW) affects the value of the multiplier.
The size of the MPW determines how much income is withdrawn from the circular flow via saving, taxation, and imports. A high MPW means that more income is leaked out at each round of spending, reducing the multiplier. This results in a smaller overall increase in national income following an injection. Conversely, a low MPW means more income is re-spent within the economy, increasing the multiplier effect. The relationship is inverse and can be calculated using the formula: multiplier = 1 ÷ MPW. Therefore, government policies will have a greater impact when MPW is low.
Assess the likely impact of a large fiscal multiplier on the effectiveness of government spending in a recession.
A large fiscal multiplier amplifies the impact of government spending, making it more effective in boosting demand and output during a recession. Increased public expenditure generates further income and consumption, raising GDP significantly. This can reduce unemployment and restore confidence. However, the effectiveness depends on the economic context. If leakages such as imports or savings are high, the actual multiplier may be smaller. Time lags and supply constraints may also limit the immediate effects. Nonetheless, with spare capacity in the economy, a large multiplier can make fiscal policy a powerful tool for recovery.
