B.Sc. in Agricultural Economics (Hons.
) Level-3 Semester- I
Course Title: Macro Economics -II (Theory) Course Code: - AGEC-333
Lecture – 4
Multiplier
In economics, a multiplier broadly refers to an economic factor that, when increased or changed,
causes increases or changes in many other related economic variables. In terms of gross
domestic product, the multiplier effect causes gains in total output to be greater than the change
in spending that caused it. The term multiplier is usually used in reference to the relationship
between government spending and total national income.
A multiplier is simply a factor that amplifies or increase the base value of something else. A
multiplier of 2x, for instance, would double the base figure. A multiplier of 0.5x, on the other
hand, would actually reduce the base figure by half. Many different multipliers exist in finance
and economics.
The multiplier effect
Every time there is an injection of new demand into the circular flow of income there is likely
to be a multiplier effect. This is because an injection of extra income leads to more spending,
which creates more income, and so on. The multiplier effect refers to the increase in final
income arising from any new injection of spending.
The size of the multiplier depends upon household’s marginal decisions to spend, called the
marginal propensity to consume (MPC), or to save, called the marginal propensity to
save (MPS). It is important to remember that when income is spent, this spending becomes
someone else’s income, and so on. Marginal propensities show the proportion of extra income
allocated to particular activities, such as investment spending by Bangladesh firms, saving by
households, and spending on imports from abroad. For example, if 80% of all new income in
a given period of time is spent on Bangladesh products, the marginal propensity to consume
would be 80/100, which is 0.8.
The following general formula to calculate the multiplier uses marginal propensities, as follows:
1
1- MPC
Hence, if consumers spend 0.8 and save 0.2 of every £1 of extra income, the multiplier will be:
1
1- 0.8
1
= 0.2
= 5
Hence, the multiplier is 5, which means that every £1 of new income generates £5 of extra
income.
Types of multiplier
i. The Fiscal Multiplier
The fiscal multiplier is the ratio of a country's additional national income to the initial boost in
spending or reduction in taxes that led to that extra income. For example, say that a national
government enacts a $1 billion fiscal stimulus and that its consumers' marginal propensity to
consume (MPC) is 0.75. Consumers who receive the initial $1 billion will save $250 million
and spend $750 million, effectively initiating another, smaller round of stimulus. The recipients
of that $750 million will spend $562.5 million, and so on.
ii. The Investment Multiplier
An investment multiplier similarly refers to the concept that any increase in public or private
investment has a more than proportionate positive impact on aggregate income and the general
economy. The multiplier attempts to quantify the additional effects of a policy beyond those
immediately measurable. The larger an investment's multiplier, the more efficient it is at
creating and distributing wealth throughout an economy.
iii. The Earnings Multiplier
The earnings multiplier frames a company's current stock price in terms of the
company's earnings per share (EPS) of stock. It presents the stock's market value as a function
of the company's earnings and is computed as price per share/earnings per share (commonly
called the earnings multiple).
iv. The Equity Multiplier
The equity multiplier is a commonly used financial ratio calculated by dividing a company's
total asset value by total net equity. It is a measure of financial leverage. Companies finance
their operations with equity or debt, so a higher equity multiplier indicates that a larger portion
of asset financing is attributed to debt. The equity multiplier is thus a variation of the debt ratio,
in which the definition of debt financing includes all liabilities.
v. The Keynesian Multiplier Theory
One popular multiplier theory and its equations were created by British economist John
Maynard Keynes. Keynes believed that any injection of government spending created a
proportional increase in overall income for the population, since the extra spending would carry
through the economy. In his 1936 book, "The General Theory of Employment, Interest, and
Money," Keynes wrote the following equation to describe the relationship between income (Y),
consumption (C) and investment (I):
Y = C+1
The equation states that for any level of income, people spend a fraction and save/invest the
remainder. He further defined the marginal propensity to save and the marginal propensity to
consume (MPC), using these theories to determine the amount of a given income that is
invested. Keynes also showed that any amount used for investment would be reinvested many
times over by different members of society.
vi. The Fractional Reserve Money Multiplier
Assume a saver invests $100,000 in a savings account at his or her bank. Because the bank is
only required to maintain a portion of that money on hand to cover deposits, it can loan out the
remainder of the deposit to another party. Assume the bank loans out $75,000 of the initial
deposit to a small construction company, which uses it to build a warehouse. Over time, if the
bank continues to lend up to its required reserve ratio R=25%, the amount of additional demand
deposits or “money” created by the initial deposit will be 1/R or 1/.25 = 4 times, which is
typically called the Money Multiplier.
The funds spent by the construction company go to pay electricians, plumbers, roofers, and
various other parties to build it. These parties then go on to spend the funds they receive
according to their own interests. The $100,000 has earned a return for the investor, the bank,
the construction company, and the contractors that built the warehouse. Since Keynes' theory
showed that investment was multiplied, increasing incomes for many parties, Keynes coined
the term "multiplier" to describe the effect.
The deposit multiplier is frequently confused or thought to be synonymous with the money
multiplier. However, although the two terms are closely related, they are not interchangeable.
If banks loaned out all available capital beyond their required reserves, and if borrowers spent
every dollar borrowed from banks, then the deposit multiplier and the money multiplier would
be essentially the same.
In actual practice, the money multiplier, which designates the actual multiplied change in a
nation's money supply created by loan capital beyond bank's reserves, is always less than the
deposit multiplier, which can be seen as the maximum potential money creation through the
multiplied effect of bank lending.
