What Is the Multiplier Effect?

The multiplier effect is an economic term, referring to the proportional amount of increase, or decrease, in final income that results from an injection, or withdrawal, of capital. in effect, It measures the impact that a change in economic activity—like investment or spending—will have on the total economic output of something.

Key Takeaways

  • The multiplier effect refers to the proportional amount of increase, or decrease, in final income that results from an injection, or withdrawal, of spending.
  • The most basic multiplier used in gauging the multiplier effect is calculated as change in income / change in spending and is used by companies to asses investment efficiency.
  • Money supply multiplier, or just the money multiplier, looks at a multiplier effect from the perspective of banking and money supply.

Multiplier Effect

Understanding the Multiplier Effect

Generally, economists are usually the most interested in how infusions of capital positively affect income. Most economists believe that capital investments of any kind—whether it be at the governmental or corporate level—will have a broad snowball effect on various aspects of economic activity.

As its name suggests, the multiplier effect provides a numerical value or estimate of a magnified expected increase in income per dollar of investment. In general, the multiplier used in gauging the multiplier effect is calculated as follows:

Multiplier = Change in Income Change in Spending \begin{aligned}\text{Multiplier}=\frac{\text{Change in Income}}{\text{Change in Spending}}\end{aligned} Multiplier=Change in SpendingChange in Income

The multiplier effect can be seen in several different types of scenarios and used by a variety of different analysts when analyzing and estimating expectations for new capital investments.

Example of the Multiplier Effect

For example, assume a company makes a $100,000 investment of capital to expand its manufacturing facilities in order to produce more and sell more. After a year of production with the new facilities operating at maximum capacity, the company’s income increases by $200,000. This means that the multiplier effect was 2 ($200,000/$100,000). Simply put, every $1 of investment produced an extra $2 of income.

The Keynesian Multiplier

Many economists believe that new investments can go far beyond just the effects of a single company’s income. Thus, depending on the type of investment, it may have widespread effects on the economy at large. A key tenet of Keynesian economic theory is that of the multiplier, the notion that economic activity can be easily influenced by investments, causing more income for companies, more income for workers, more supply, and ultimately greater aggregate demand.

Essentially, the Keynesian multiplier is a theory that states the economy will flourish the more the government spends, and the net effect is greater than the exact dollar amount spent. Different types of economic multipliers can be used to help measure the exact impact that changes in investment have on the economy.

For example, when looking at a national economy overall, the multiplier would be the change in real GDP divided by the change in investments, government spending, changes in income brought about by changes in disposable income through tax policy, or changes in investment spending resulting from monetary policy via changes in interest rates.

Some economists also like to factor in estimates for savings and consumption. This involves a slightly different type of multiplier. When looking at savings and consumption, economists might measure how much of the added income consumers are saving versus spending. If consumers save 20% of new income and spend 80% of new income, then their marginal propensity to consume (MPC) is 0.8. Using an MPC multiplier, the equation would be:

MPC Multiplier = 1 1 MPC = 1 1 0.8 = 5 where: MPC = Marginal propensity to consume \begin{aligned}&\text{MPC Multiplier}=\frac{1}{1-\text{MPC}}=\frac{1}{1-0.8}=5\\&\textbf{where:}\\&\text{MPC}=\text{Marginal propensity to consume}\end{aligned} MPC Multiplier=1MPC1=10.81=5where:MPC=Marginal propensity to consume

Therefore, in this example, every new production dollar creates extra spending of $5.

Money Supply Multiplier Effect

Economists and bankers often look at a multiplier effect from the perspective of banking and a nation's money supply. This multiplier is called the money supply multiplier or just the money multiplier. The money multiplier involves the reserve requirement set by the Board of Governors of the Federal Reserve System and it varies based on the total amount of liabilities held by a particular depository institution.

In general, there are multiple levels of money supply across the entire U.S. economy. The most familiar ones are:

  • The first level, dubbed M1, refers to all of the physical currency in circulation within an economy.
  • The next level, called M2, adds the balances of short-term deposit accounts for a summation.

When a customer makes a deposit into a short-term deposit account, the banking institution can lend one minus the reserve requirement to someone else. While the original depositor maintains ownership of their initial deposit, the funds created through lending are generated based on those funds. If a second borrower subsequently deposits funds received from the lending institution, this raises the value of the money supply even though no additional physical currency actually exists to support the new amount.

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. The size of the multiplier depends on the percentage of deposits that banks are required to hold as reserves. When the reserve requirement decreases the money supply reserve multiplier increases and vice versa.

Back in 2020, prior to the Covid-19 pandemic, the Fed mandated that institutions with more than $127.5 million have reserves of 10% of their total deposits. However, as the pandemic sparked an economic crisis, the Fed took a dramatic step: On Mar. 26, 2020, it reduced the reserve ratio to 0%—essentially, eliminating these requirements entirely to free up liquidity.

Money Supply Reserve Multiplier

Most economists view the money multiplier in terms of reserve dollars and that is what the money multiplier formula is based on. Theoretically, this leads to a money (supply) reserve multiplier formula of:

MSRM = 1 RRR where: MSRM = Money supply reserve multiplier RRR = Reserve requirement ratio \begin{aligned}&\text{MSRM}=\frac{1}{\text{RRR}}\\&\textbf{where:}\\&\text{MSRM}=\text{Money supply reserve multiplier}\\&\text{RRR}=\text{Reserve requirement ratio}\end{aligned} MSRM=RRR1where:MSRM=Money supply reserve multiplierRRR=Reserve requirement ratio

For example, in the case of banks with the highest required reserve requirement ratio—10% prior to Covid-19—their money supply reserve multiplier would be 10 (1/.10). This means every one dollar of reserves should have $10 in money supply deposits.

If the reserve requirement is 10%, then the money supply reserve multiplier is 10 and the money supply should be 10 times reserves. When a reserve requirement is 10%, this also means that a bank can lend 90% of its deposits.

Money Supply Reserve Multiplier Example

Image by Sabrina Jiang © Investopedia 2020

Looking at the money multiplier in terms of reserves helps one to understand the amount of expected money supply. In this example, $651 equates to reserves of $65.13. If banks are efficiently using all of their deposits, lending out 90%, then reserves of $65 should result in a money supply of $651.

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.

What Is a Multiplier?

In economics, a multiplier broadly refers to an economic factor that, when changed, causes changes in many other related economic variables. The term is usually used in reference to the relationship between government spending and total national income. In terms of gross domestic product, the multiplier effect causes changes in total output to be greater than the change in spending that caused it.

How Does the Multiplier Effect Fit into Keynesian Economics?

The multiplier effect is one of the chief components of Keynesian countercyclical fiscal policy. A key tenet of Keynesian economic theory is the notion an injection of government spending eventually leads to added business activity and even more spending which boosts aggregate output and generates more income for companies, This would translate to more income for workers, more supply, and ultimately greater aggregate demand.

How Is the Multiplier Effect Related to MPC?

The magnitude of the multiplier is directly related to the marginal propensity to consume (MPC), which is defined as the proportion of an increase in income that gets spent on consumption. For example, if consumers save 20% of new income and spend the rest, then their MPC would be 0.8 {1 - 0.2}. The multiplier would be 1 ÷ (1 - 0.8) = 5. So, every new dollar creates extra spending of $5. Essentially, spending from one consumer becomes income for a business that then spends on equipment, worker wages, energy, materials, purchased services, taxes, and investor returns. When a worker from that business spends their income, it perpetuates the cycle.