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Multiplier in Economics: Definition, Effect & Formula

Multiplier in Economics: Definition, Effect & Formula
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  • 0:03 An Economy in Trouble
  • 1:23 Marginal Propensity to Consume
  • 2:03 Calculating the Multiplier
  • 2:55 The Multiplier Effect
  • 4:14 Lesson Summary
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Lesson Transcript
Instructor: Adam Gifford
When the government attempts to stimulate the economy through increased spending, how do they know how much to increase spending by? That question is answered by understanding the multiplier in economics.

An Economy in Trouble

Let's say the economy of the fictitious country of Bushidostan has been steadily slowing down for the past decade. The government has been trying a number of different things to increase the economy back to a healthy level. One of many attempts includes an increase in spending by the government. The thought here is that the government will spend more money within the economy and that money will then be spent by the residents of Bushidostan. Once the residents start spending more money, the economy should regain its momentum. The government of Bushidostan will accomplish this increase in spending by building additional roads and schools. They will also send each resident a sum of money in addition to their annual tax refunds. This government has just enacted the Keynesian Economic Policy, which is when a government increases spending and money distribution for the purpose of economic stimulation.

This theory of economic recovery uses a metric known as the multiplier to measure its effectiveness. The multiplier is the amount of new income that is generated from an addition of extra income. The new income is money spent by the residents of Bushidostan. The extra income is the additional amount that will be spent by the government of Bushidostan.

Marginal Propensity to Consume

The government of Bushidostan knows that for every extra dollar that the residents receive they will spend $.75 and save $.25. They know this based on historical data from other times in their past when they enacted similar efforts. The amount that they will spend is known as the marginal propensity to consume. The marginal propensity to consume is the proportion of money that will be spent when a person receives a certain amount of money. In this case, the marginal propensity to consume for the residents of Bushidostan is $.75 since they will spend $.75 of every $1.00 that they receive.

Calculating the Multiplier

Once the government of Bushidostan knows the marginal propensity to consume, it can calculate the multiplier. For the formula, we will use M to represent multiplier and MPC to represent marginal propensity to consume.

The formula to determine the multiplier is:

M = 1 / (1 - MPC)

Since we already know the marginal propensity to consume for the residents of Bushidostan is 0.75, we can calculate the multiplier for Bushidostan.

M = 1 / (1 - .75)

M = 1 / .25

M = 4

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