The money multiplier, or monetary multiplier, is the increase in total monetary supply due to bank reserve requirements. Banks are required to keep a certain amount of customer deposits on reserve, but they can lend out the remainder to generate interest. In the United States, banks must keep 10% of customer deposits on reserve, meaning that they can lend out 90% of customer deposits and increase the money supply tenfold. Other countries have different reserve requirements, and central banks can enact monetary policy by adjusting reserve requirements. The money supply multiplier effect can be seen in a country’s banking system. An increase in bank lending should translate to an expansion of a country’s money supply.
Multipliers are also used in explaining fractional reserve banking, known as the deposit multiplier. In economics, a multiplier broadly refers to an economic factor that, when increased or changed, causes increases or changes in many other related economic variables. In terms of gross domestic product (GDP), the multiplier effect causes gains in total output to be greater than the change in spending that caused it. If banks are lending more than their reserve requirement allows, then their multiplier will be higher, creating more money supply. If banks are lending less, then their multiplier will be lower and the money supply will also be lower. Moreover, when 10 banks were involved in creating total deposits of $651.32, these banks generated a new money supply of $586.19, for a money supply increase of 90% of the deposits.
- In other cases, the multiplier effect is a product of public policy or corporate governance.
- They use that income to pay their bills, paying wages and salaries to their workers, rent to their landlords, payments for the raw materials they use.
- This money is used to hire workers, buy materials, and pay for other services.
- One dollar of government spending will generate more than a dollar in economic growth.
- In terms of gross domestic product (GDP), the multiplier effect causes gains in total output to be greater than the change in spending that caused it.
Multiplier Effect Formula
Injections are exports, investments, and government spending because they increase the supply of money flowing through the economy. The expenditure multiplier (also known as the spending multiplier) tells us the total rise in GDP that results from each additional dollar initially spent. It is a ratio of the total change in GDP due to autonomous change in aggregate spending to the size of that autonomous change. In economics, the multiplier effect refers to the result a change in spending has on real GDP. The change in spending may be a result of an increase in government expenditure or a change in the tax rate. Find the expenditure multiplier if consumer spending increases by $50, and disposable income increases by $100.
Multiplier Theory in Economics
These changes will reduce aggregate expenditures, and then will have an even larger effect on real GDP because of the multiplier effect. Read the following Clear It Up feature to learn how the multiplier effect can be applied to analyze the economic impact of professional sports. The multiplier theory refers to when an economic factor increases, it generates a higher total of other economic variables than the increase of the initial factor. When there is an autonomous change in aggregate spending more money is spent in the economy.
Consumers who receive the initial $1 billion will save $250 million and spend $750 million, effectively initiating another, smaller round of stimulus. With a high multiplier, any change in aggregate demand will tend to be substantially magnified, and so the economy will be more unstable. With a low multiplier, by contrast, changes in aggregate demand will not be multiplied much, so the economy will tend to be more stable.
MULTIPLIER TRADEOFFS: STABILITY VERSUS THE POWER OF MACROECONOMIC POLICY
This would translate to more income for workers, more supply, and ultimately greater aggregate demand. The MPC is in the place of the 1 in the numerator because people do not spend the entire equivalent of their tax cut, just like they do not spend all their disposable income. They only spend in proportion to their MPC and save the rest, unlike in the expenditure formula where $1 in spending increases real GDP and disposable income by $1. The tax multiplier is negative because of the inverse relationship where an increase in taxes causes a decrease in spending. The tax multiplier formula helps us calculate the effect of a tax policy on GDP.
Then there is the tax multiplier which is the amount by which a change in the level of taxes affects GDP. Examples of the multiplier effect in economics are the expenditure multiplier and the tax multiplier. The tax multiplier is the amount by which a change in the level of taxes affects GDP.
In Keynesian macroeconomic theory, the marginal propensity to consume is a variable in showing the multiplier effect of economic stimulus spending. It suggests that a boost in government spending will increase consumer spending. The four sector economy is made up of households, firms, the government, and the foreign sector. As seen in Figure 1, money flows through these four sectors through government spending and investing, taxes, private income, and spending, as well as imports and exports in a circular flow.
To understand the multiplier effect, let’s consider an example involving government spending. Suppose the government decides to invest $1 billion in building new infrastructure projects, such as roads, bridges, and schools. This injection of government spending creates jobs for construction workers, engineers, and other related industries. If the MPC is high and people spend more of their income, injecting it back into the economy, the multiplier effect will be stronger and therefore the effect on the total real GDP will be greater. When society’s MPS is high, they save more, the multiplier effect is weaker, and the total real GDP effect will be smaller. Therefore the MPC will always be a number between 0 and 1 because the change in disposable income will exceed the change in consumer spending.
When the dust which of the given multipliers will cause settles the amount of new income generated is multiple times the initial increase in spending–hence, the name the spending multiplier. The table below gives an example of how this could work with an increase in government spending. Note that the multiplier works the same way in reverse with a decrease in spending.
For example, the fiscal multiplier, also known as the Keynes-Kahn multiplier was the first one to emerge and is the most well-known type of multiplier effect. As explained in the book A Concise Guide to Macroeconomics (Moss, 2014), it looks at the effect of changing government spending on gross domestic product (or national income) in an economy. As shown in the calculations in Figure B.10 and Table B.4, out of the original $100 in government spending, $53 is left to spend on domestically produced goods and services.