The multiplier effect

Overview

The multiplier effect and how an injection multiplies through the economy, the multiplier formula and the marginal propensity to consume, the three withdrawals, calculating the multiplier and the rise in national income, imports, the multiplier in reverse after a closure, injections that raise prices, the accelerator effect, and why the multiplier is hard to predict.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Define the multiplier effect.

   Model answer

   The multiplier effect is the process by which an initial injection of spending produces a larger eventual rise in national income, because the money is spent and re-spent in successive rounds.

2. 2

   How does an injection of spending multiply through the economy?

   Model answer

   The initial spending becomes income for firms and their workers, who spend a proportion of it on other goods and services, which becomes income for others in turn, so each round adds a smaller amount until the leakages exhaust it.

3. 3

   State the formula for the multiplier in terms of the marginal propensity to consume.

   Model answer

   The multiplier equals 1 ÷ (1 − MPC), where MPC is the marginal propensity to consume.

4. 4

   Define the marginal propensity to consume.

   Model answer

   The marginal propensity to consume is the proportion of any additional income that households spend on consumption rather than save.

5. 5

   Name the three withdrawals that determine the size of the multiplier.

   Model answer

   The three withdrawals are saving, taxation and spending on imports.

6. 6

   An economy has a marginal propensity to consume of 0.6. Calculate the multiplier.

   Model answer

   The multiplier is 1 ÷ (1 − 0.6) = 1 ÷ 0.4 = 2.5.

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