Multiplier Effect Explained
Quick Definition: The multiplier effect is when an increase in government spending has a greater impact on the economy than the initial amount spent.
What is the multiplier effect?
The multiplier effect is a concept in economics that describes how an injection into an economy, such as an increase in government spending, creates a ripple effect which increases employment and the output of goods and services in the economy.
How does it work?
- An injection occurs in the economy, such as an increase in government spending.
- The injection increases the aggregate demand in the economy for goods and services.
- The increase in demand for goods and services causes firms to employ more workers and expand output.
- As firms are employing more workers, more people have disposable incomes and subsequently the aggregate demand increases in the economy.
- The increases in aggregate demand causes firms to employ more workers and the effect continues as before.
- Aggregate demand – This refers to the total of all the demand in an economy. The equation for aggregate demand is: Consumption (C) + Government Spending (G) + Investment (I) + (Exports (X) – Imports (M)).
- Economy – A system that provides goods and services.
- Gross domestic product (GDP) – This is the total value of all goods and services produced in an economy during a set period of time.
- Injections – Injections increase the demand for domestically produced goods and services. Injections come from investment, government spending and export sales.