Wednesday, 22 June 2011

The Multiplier (Macroeconomics)

The Multiplier is a concept developed by John Maynard Keynes. He was a famous economist born in 1883, he passed away in 1946. His concept said that "any increase in injections into the economy (investment, government expenditure or exports) would lead to a proportionally bigger increase in National Income." Basically, this translates to any new money being pumped into the economy will have a larger effect on GDP than the initial injection.

Why is this? Well, because one persons spending is another persons income, and that income will increase their purchasing power and hence their spending.

Lets try an example. Say i had £100 in my pocket. I gave all that money to my friend for looking after my dog for the day. Then, that person puts £25 into savings and spends the remaining £75 on a new TV from a guy they met. This guy then saves £25 and uses the remaining £50 to pay a neighbor to wash his car. This cycle could go on and on, but lets leave it there and say the neighbor puts all £50 into savings. The initial £100 has now exited the economy. However, on its way through the economy it has had a larger effect on GDP. The £100 turned into (100+75+50) £225 worth of spending in the economy.. and thus shows that the multiplier is a true theory.

The multiplier has a few equations related to it:

  • The Multiplier = 1 ÷ MPW
  • Change in GDP = Initial injection x (1 ÷ MPW)

MPW stands for marginal propensity to withdraw. This is the proportion of any extra income that we save, spend on imports or is taxed. 

That's the theory behind the multiplier effect, briefly put. Thanks for reading. 

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