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The Multiplier Effect in Economics: Definition, Formula & Example

The Multiplier Effect in Economics: Definition, Formula & Example
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Lesson Transcript
Instructor: Monica Gragg

Monica has taught college-level courses in Tourism, HR and Adult Education. She has a Master's in Education and is three years into a PhD.

In this lesson, we'll examine the multiplier effect, which is a chain reaction of activities that stimulate the economy. Then we'll look at some examples and a formula that can be applied to any scenario to help explain the multiplier effect.

The Multiplier Effect & Its Appeal

Every few years, hundreds of countries bid on hosting the World Cup. The attraction of hosting the World Cup is the substantial boost to the nation's economy. The preparation of new stadiums and infrastructure alone creates thousands of jobs. But job creation is only one element of hosting the World Cup. The real appeal is an economic concept called the multiplier effect.

You see, the selected country will use the World Cup as an injection into the economy. This multiplier effect creates a new demand for goods and services, which then creates a chain reaction of expenditures and consumption. A chain reaction is a series of events that were each caused by the previous one. This is what the multiplier effect means.

Multiplier Effect Example: Brazil

Let's look at Brazil as an example. When Brazil won the World Cup bid, they spent millions of dollars building new stadiums, hotels, and infrastructure. This created thousands of new jobs and more work in the construction business. As a result, there are more people employed and employees earned more. This is especially important because this meant they spent more on local goods and services.

Aside from job creation, industries that support the construction industry also benefited. This is commonly known as backwards linkage, also known as indirect impacts, which are when related economic activities benefit from a boost in one economic activity. Looking at stadiums specifically, the Brazilian government built 12 new stadiums for the World Cup. Stadiums require turf, stadium seating, lighting, parking lots, interior design, and other goods and services. So that means there is also a large boost in those industries.

Examples of the Multiplier Effect

The multiplier effect isn't just limited to mega sporting events like the World Cup or the Olympics. It actually occurs quite frequently. Banks and governments work together to create a multiplier effect. Governments require banks to hold a percentage of money in reserve so that the banks can lend more money in the future. It creates a cycle, which allows more people to borrow and spend on goods and services like real estate, cars, and retail. The more people spend on goods and services, the greater the multiplier effect and economic boost.

Marginal Propensity to Consume (MPC)

MPC is the marginal propensity to consume. Simply put, it's the extra income that can be used for consumption. It's represented by the formula MPC = mC / mY, in which the mC is the change in consumption and the mY is the change in income. So, if a company or single person earns an extra $100 and spends $80, the MPC is 0.8.

The MPC is important because it shows us how much companies or individuals are willing to spend with extra revenue or income. Ultimately, this will determine the size or nature of the multiplier effect. Their willingness is influenced by several factors. Here are some examples.

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