What is Multiplier Analysis?
The word multiplier means when something is getting multiplied or the effect of something when it is multiplied. Therefore, from the economic point of view, it can be said that a multiplier is something that evaluates or measures the effect on equilibrium due to changes in the components of aggregate demand.
Now, what is aggregate demand? Aggregate demand refers to the total amount of demand for goods and services that have been demanded in an economy during a specific period of time. The components of aggregate demand are quite basic since it is the aggregate demand. This means that when individuals are willing to spend money in some way or the other it can be consumed, it can be an investment. In simpler words, we can say that when some money expenditure is done on certain products that are known as or that comes under the component of aggregate demand. Thus, the components of aggregate demand are:
- Government expenditure
- Net export
In this case, the example of a closed economy can be stated, which means there will be no export or import, or in other words, it can be said that there will be no trade. Thus, components of aggregate demand are reduced to only consumption, investment, and government expenditure. Now multiplier can be defined as the change in any one of the components of the aggregate demand which results in a multiplied change in the equilibrium level of the gross domestic product of a country or an economy. Now the question comes what is the gross domestic product? Gross domestic product is defined as the market value of all final goods and services produced within the domestic territory of a country within a given period of time. There are certain features of multiplier which resembles multiplier as the name suggests:
- The multiplier effect comes because of the fact of injections of new demand for goods and services into the economy or more specifically into the circular flow of income which in turn further stimulates the round of funding; this because of the fact that one person's spending is another individual's income.
- The multiplier effect results in a larger effect on the level of the national output and also the total amount of employment which is in the labor market and ultimately in the entire economy
How to Calculate the Multiplier Effect?
The formula for calculating the value of multiplier is:
Multiplier= 1/ 1 – MPC
MPC is the marginal propensity to consume.
But before understanding the formula of the multiplier, it is important to have the idea of what is the propensity to consume and propensity to save.
Propensity to consume refers to the phenomena in which the behavior of the individual is analyzed in terms of the fact that how much he is willing to spend on consumption out of his income.
Propensity to save refers to the phenomena which explain the behavior of the individual and evaluate it in terms of the fact that how much the individual is willing to save out of his income.
From the point of view of macroeconomics, it can be said that multiplier acts as the factor of proportionality that evaluate or analyses that how much of an endogenous variable change or the sensitivity of the endogenous variable with change in the exogenous variable. The theory of multiplier was developed in the 1930s during the time of economic recession by Keynes and other famous economists.
The multiplier effect process can be explained with the help of an example:
The government plans and also implements to inject, $ 400,000,000 in a project to build all large number of affordable new schools. In other words, it can be said that the government is spending 400,000,000 dollars. Therefore, a new school building project injects $ 400 million of extra demand and output into the economy. Also, many businesses benefit directly including the building supply, industries, architects, etc. Constructing new schools generates a new flow of income in the form of wages and profits. Now a question arises that will this extra income stay inside the circular flow of income? The answer is that if it does stay inside, the multiplier effect can be assumed to be very strong and the final result impact on the gross domestic product again is assumed to be quite large. Therefore, the injection of 400,000,000 dollar projects will end up having a greater effect on the GDP than it can be imagined.
Therefore, if the final rise in GDP is 600,000,000, then the value of multiplier is:
Value of multiplier= change in GDP/ initial injection
= (600/400) millions
Again, if we take an example where the final rise in the GDP is 500,000,000 then the value of multiplier will be:
Value of multiplier= change in GDP/ initial injection
= (500/400) millions
Factors Affecting the Value of Multiplier
There are two cases in which there are different factors that affect the multiplier, one is the high multiplier value and the other is the low multiplier value. In the beginning we can see the case of high multiplier value:
- When the value of the multiplier is high this means that the economy is having enough spare capacity or it can be said that there is excess capacity to meet the higher aggregate demand in the economy.
- The marginal propensity to import or the wish of the economy to import goods and services from the other countries and the tax is low.
- It is also assumed that there is a high propensity to consume or the consumer is having some extra income to spend. This also means that the consumer is having a low tendency to save his or her money.
The next case is when the value of the multiplier is low:
- This is a scenario when the economy is very near to its capacity limits for example this happens during the phase of a boom of the economic cycle.
- The economy has more tendency to import goods and services from other countries. This means that the income of the economy is going out while purchasing goods and services from other countries which is creating leakage in the circular flow of income.
- Another reason for the multiplier value is low is that there is a higher level of inflation which causes the rise in the interest rate which in turn dampens the growth of other components of the aggregate demand.
To analyze or evaluate what kind of effect multiplier can have based on the situation prevailing in the economy, multiplier analysis is important.
There are certain assumptions when a simple multiplier effect is taken into consideration:
- There is no tax or imports.
- The only way of a leakage in the circular flow of income and spending is the saving of the individuals or the households in the economy.
- Multiplier coefficient K= 1/(1-MPC).
- For example, if the marginal propensity to consume is 0.6, this means that there is 60% of extra income with the individual who is willing to spend it.
- Now the value of multiplier will be= 1/ (1-0.6)
What is the Fiscal Policy Multiplier?
Next is the concept of fiscal multiplier: fiscal multiplier refers to the phenomena in which the change in the national income is evaluated due to a change in government spending. More specifically it is the exogenous spending multiplier is the change in national income due to an autonomous change in spending, the government, or due to the spending of an individual or a household as well.
What Determines the Size of the Fiscal Multiplier?
Government spending, which can be a kind of investment as well, for example, construction of new infrastructures such as new schools or affordable houses- often leads to higher multiplier effects.
The economists at the International Monetary Fund have calculated that the long-run multiplier value is at +1.5 for developed countries and +1.6 for developing countries.
How the Multiplier Analysis is useful in Formulating Fiscal Policy?
This is one of the most common questions that arise when the discussion of the multiplier analysis comes in terms of formulating the fiscal policy. Since the fiscal policy involves the use of two tools namely the government expenditure and the taxation method. In a fiscal policy, the government either increases the expenditure or decreases the taxation to boost the aggregate demand in the economy. The government implements fiscal policies based on the need of the economy, alters the government spending to have a higher value of multiplier or lower value of the multiplier.
Context and Applications:
This topic is significant in the professional exams for both undergraduate and graduate courses, especially for
- B.A. in economics
- M.A. in economics
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