The multiplier effect reflects the governments attempt to increase aggregate demand since the initial sum of government expenditure, or injections, would increase as it goes through the economy. This would in turn stimulate factors in AD, moving it the AD curve to the right, thus stimulating the economy and achieving macroeconomic goals. The multiplier effect is a ratio of change in national income to an initial change in one or more of the injections into the circular flow of income. Changes in AD could effect the national income, or GDP, more than just the value of change. It is a chain reaction in which the sum injected into the economy would end up more than what it was initially. For example, when the government spends more money on health care, this money would be used to buy new equipment, to improve facilities and for other medical goods and services. The consumption of these goods would then increase and therefore increases the profits of these producers that make these equipments.
Some of the money would be given to the doctors and nurses or used to hire more medical workers. This would also affect AD since with the money, they will buy other goods and services for their own wants and needs like food, clothes, etc. This would then increase the consumption of these goods, thus increasing profits of these producers.
The rate or amount passed on in this chain diminishes but it will still be more than what it was originally. The ratio is calculated by dividing the change in GDP by the change in injections. For example, if the increase in GDP was $100 m and the increase in government spending was $50m then there is a multiplier of 2. There are three key factors that determine the value of multiplier which are all leakages:
- The size of the savings ratio
- The amount of expenditure on imports
- The level of taxation
An increase going in could also mean in an increase of money out of the economy. A larger amount of savings means a smaller multiplier value since it the money doesn’t pass on. An increase in pay would also mean more people spending more money on imported goods which is also money lost on the economy. An increase in pay also means higher taxation. This would go back to the government which would also leave the economy. This would be somewhat of an exception if the government uses this money for the public sector or employment where the money would return to the economy. Because of these factors, the multiplier value would depend on how much of people’s income is spent on consumption which is know as the marginal propensity to consume. The multiplier value would then be 1/ 1-MPC which is the marginal propensity to consume.
