The Multiplier Effect Explained
The multiplier effect is an economic term used to describe the phenomenon whereby an initial injection of capital into the economy has a larger ultimate increase in the national income than the amount initially spent.
In this article, we will explore this concept in detail. We will explain how an investment in one area of the economy can filter through to others, ultimately boosting its overall impact and, more importantly, how investors can potentially leverage this information to their advantage.
Table of Contents
Understanding the Multiplier Effect
The multiplier effect is the idea that an initial change in aggregate demand (total demand within an economy) can have a larger ultimate impact on total national output than the initial change.
We’ll dive into the logic of this shortly but, firstly, we’ll quickly explain what we mean by total output, as understanding this is integral to properly understanding the multiplier effect.
Total output is the total value of all goods and services produced and sold within an economy and is typically measured by Gross Domestic Product (GDP) which, in turn, is used to measure the size of an economy.
In theory, an economy’s total output, total income and total spending should all be of equal value (total output = total spending = total income). Consequently, an economy’s GDP can be established by calculating any one of these three figures, calculations which are known respectively as: the output method, the income method and the expenditure method.
Of the three, the expenditure method is the most commonly used, and it is calculated thus:
| GDP = Consumption + Investment + Government Spending + Net Exports* |
* Net Exports = Exports – Imports
Anytime one of these variables increases, GDP also increases.
Multiplier Effect Explained
The multiplier effect occurs when an initial injection of capital into the economy causes a larger final increase in total national income (GDP) than the initial injection. How is this possible?
Essentially, the multiplier effect happens due to the fact that one agent’s spending is another agent’s income. This results in money circulating throughout the economy and being spent multiple times by different agents.
For example, when an investment creates new jobs, these new employees will spend a portion of their wages elsewhere within the economy. This expenditure translates into income for somebody else who, in turn, spends the money elsewhere. And so, the cycle goes on.
This is probably best understood by looking at an example, which we will do in due course.
The Injection of Capital
Typically, when people talk about the multiplier effect, the injection of capital which is being analysed is government spending. However, it can be used to analyse any instance where an injection of capital has led to an increase in aggregate demand, such as the following:
- Taxation
- A decrease in taxation puts more money in people’s pockets. Whilst some of this money may be saved in the bank, some of it will also be spent, leading to an increase in consumption and aggregate demand.
- Interest Rates
- Lower interest rates reduce the cost of servicing debt, which, again, puts more money in people’s pockets. The lower cost of borrowing can also encourage people to borrow money in order to fund larger purchases. Again, this should lead to an increase in aggregate demand.
- Net Exports
- If net exports increase, more money is coming into the economy via exports. All else being equal, this will lead to an increase in aggregate demand.
- Investment
- Of course, the initial investment does not necessarily need to come from the government. It can be the case that a business or a foreign investor makes an investment, such as building new infrastructure or expanding their business. Again, this injection of capital will lead to an increase in aggregate demand.
In the following section, we will look at a more detailed example which uses government spending. However, we could just as easily have analysed an increase in aggregate demand caused by any of the above factors.
How the Multiplier Effect Works
Let’s consider a real-life example of the multiplier effect by looking at how an initial investment by the government can have a ripple effect throughout the economy.
The current government in the UK has pledged to build 1.5 million new homes during their term. Let's say that they allocate a figure of £5 billion towards housebuilding projects. Without delving into exactly how and where this money will be spent, let’s take a look at how this investment could theoretically benefit the economy through the multiplier effect.
It’s worth noting that investments in construction typically have a relatively high multiplier. Indeed, in 2020, the CBI released a report which found that every £1 invested in UK construction creates £2.92 worth of value to the UK.
The Multiplier Effect in Action
Let’s say that, of the government’s £5 billion investment in housebuilding, £3 billion is used to hire workers and pay their wages, whilst the rest is used to purchase the necessary supplies. As we saw earlier, government spending is a component of GDP, so, as a result of this investment, GDP rises by £5bn.
The workers receive their wages. Their income is taxed and some of it goes into the bank for a rainy day. But the rest is spent within the economy, increasing consumption, another component of GDP.
The suppliers receive new orders. In order to meet the increase in demand, they need to buy raw materials to increase their output and perhaps they also need to hire new workers.
Let's say that impact of all this additional expenditure increases GDP by a further £3bn. This means that GDP has increased by a total of £8bn, despite the fact the government only spent £5bn initially.
And the effect keeps on going. Wherever the money is spent next, ultimately, some may end up with other consumers who will spend some of it elsewhere. Like ripples in a pond, this is the multiplier effect in action.
This may be more easily understood visually:
It’s also worth noting that at every stage of the cycle, the government is getting some of its initial investment back - through corporation tax, income tax or VAT on expenditure.
What Influences the Multiplier Effect?
You will note that although £5bn was initially invested, only £3bn made it through to the second round of expenditure. If we kept going, we would see less money make it through to each subsequent round.
This is due to leakages along the way which will ultimately affect the size of the multiplier. For example, £3 billion of the government investment went towards paying workers; however, not all of this translates into additional expenditure.
The workers will have to pay income tax on their earnings and, if possible, they may want to save some of their money in the bank. They may also spend some money on imports. In all of these instances, money is being withdrawn from the economy.
Therefore, the multiplier will depend on what proportion of extra income is spent on consumption. This is known as the Marginal Propensity to Consume (MPC) which is calculated as follows:
| MPC = Change in Consumption / Change in Income |
If we use our workers above as an example, they received £3bn in wages from the government, which led to consumption of £2bn. Therefore, the MPC would have been 0.67 (£3bn/£2bn).
Assuming the MPC is consistent throughout the economy, the multiplier is calculated using the following formula:
| Multiplier = 1/(1-MPC) |
Learn more with Admiral Markets
Interested in learning more about the financial markets? Click the banner below to explore our wide range of educational articles:
Leveraging the Multiplier Effect for Growth
Understanding how the multiplier effect works and how the multiplier itself is calculated can allow both decision-makers and investors to make certain deductions.
Regional Development
The multiplier effect can be used to stimulate growth in specific regions of an economy, although its effectiveness will depend on the region in question. Typically speaking, there will be a greater multiplier effect in less affluent areas than in more affluent parts of a country.
This is because consumers in less affluent regions are likely to spend a higher proportion of their income relative to consumers in more affluent regions, who are more likely to save a higher proportion of their income.
Consequently, the MPC in less affluent areas is likely to be higher, which will result in a larger multiplier. This means that government spending projects in less affluent areas will bring more benefit to the local economy as well as to the wider economy as a whole.
Investing Opportunities
An understanding of the multiplier effect may also present investing opportunities to investors. For example, upon hearing about the UK government’s plans to invest in housebuilding, it might seem like a good time to invest in housebuilding companies.
However, for those that understand the multiplier effect, the government spending project may present other investment opportunities which are not initially so apparent.
As a result of the increase in housebuilding, local businesses in the areas where construction is taking place are likely to benefit from a bump in demand brought about by increased employment. Understanding this may open new avenues of potential investment.
Conclusion
The multiplier effect occurs when an initial injection of capital into the economy results in a larger ultimate increase in GDP. This is caused by money circulating throughout the economy and being spent numerous times.
In this article, we have focused on how the multiplier effect works when there is an injection of capital into the economy. However, it’s worth noting that the multiplier effect can also work in reverse, when money is withdrawn from the economy, which is known as the negative multiplier effect.
For example, a cut in government spending would cause an initial fall in GDP, which would be reinforced further down the line by less consumption elsewhere.
Investing with Admiral Markets
Start building your investment strategy today. Explore Admiral Markets by clicking the banner below:
About Admiral Markets
Admiral Markets is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
