The multiplier effect describes how an initial change in spending leads to a larger overall change in total economic activity (GDP) (Mankiw, 2024). This occurs because one person’s spending becomes another person’s income, which can lead to additional spending and further increases in economic activity.
Marginal Propensity to Consume
The size of the multiplier effect depends on the Marginal Propensity to Consume (MPC), which measures the proportion of additional income that households spend.
- Higher MPC: Households spend a larger portion of their additional income, allowing spending to continue through more rounds of the economy and resulting in a larger multiplier effect.
- Lower MPC: Households spend a smaller portion of their additional income and save more, causing the cycle of spending to weaken more quickly and resulting in a smaller multiplier effect.
Higher MPC → more spending in each round → larger multiplier effect
- The government (or a business) spends $100
- That $100 becomes someone’s income
- They spend part of it (based on MPC or Marginal Propensity to Consume)
- That spending becomes someone else’s income
- The process repeats → creating a ripple effect. How much people spend (MPC) determines how big the ripple effect is.
You can use the Multiplier Formula to determine the total increase in GDP.
If MPC = 0.8 or 80%, then the multiplier is 5.
By applying the multiplier of 5 to the initial spending amount, you can determine the multiplier effect on the growth of GDP. So, if initial spending is $100, then the total increase in GDP is $500.
Mankiw, N. G. (2024). Principles of Economics. Cengage Learning.
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