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What is a 'Multiplier'

In economics, a multiplier 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, the multiplier effect causes gains in total output to be greater than the change in spending that caused it. The term is usually used in reference to the relationship between government spending and total national income.

BREAKING DOWN 'Multiplier'

The multiplier theory and its equations were created by British economist John Maynard Keynes. Keynes believed that any injection of government spending created a proportional increase in overall income for the population, since the extra spending would carry through the economy.

The Mathematics of the Multiplier

In his 1936 book, The General Theory of Employment, Interest, and Money, Keynes wrote the following equation to describe the relationship between income (Y), consumption (C) and investment (I): Y = C + I. The equation states that for any level of income, people spend a fraction and save/invest the remainder. He further defined the marginal propensity to save and the marginal propensity to consume (MPC), using these theories to determine the amount of a given income that is invested. Keynes also showed that any amount used for investment would be reinvested many times over by different members of society. For example, assume a saver invests $100,000 in a savings account at his bank.

Because the bank is only required to maintain a portion of that money on hand to cover deposits, it can loan out the remainder of the deposit to another party. Assume the bank loans out $750,000 of the initial deposit to a small construction company, who uses it to build a warehouse. The funds spent by the construction company go to pay electricians, plumbers, roofers and various other parties to build it. These parties then go on to spend the funds they receive according to their own interests. The $100,000 has earned a return for the investor, the bank, the construction company and the contractors that built the warehouse. Since Keynes' theory showed that investment was multiplied, increasing incomes for many parties, Keynes coined the term "multiplier" to describe the effect.

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