The Multiplier Effect

Government Investment and a Deflationary Gap

Remember: Government spending and business

investment are injections into the circular flow of

income.
Any injections are MULTIPLIED through the

economy.
How does this take place?

Multiplier Example
A government spends 100m dollars on a school

building project.
This 100m goes to a vast number of people for the
factors of production they provide. (ex?)
Labour in the form of Architects, engineers, builders
etc.
So the 100m goes into the pockets of these people.
What do people do with this income?

Spending
Some of it goes back to the government as taxes.
Some is saved.
Some is spent on foreign goods.
The rest is spent on domestic goods and services.
The first 3 are withdrawals from the circular flow of

income, why?

What happens to the money spent domestically?

These new recipients of the income behave in a

similar fashion.
They pay taxes, they save, the buy imports and the
rest is spent on domestic produce.
During each round some income is withdrawn
from the circular flow and the rest stays to be respent.

Simple example
Govt. spends 100m on an economy in an attempt to

stimulate spending and increase GDP.

Of that 100m,
20% goes on taxes
10% is saved
10% is spent on imports
Remaining 60% spent on domestic goods

Marginal Propensity to Comsume or MPC

So the MPC when expressed as a decimal is 0.6
The final result of the multiplier, when all the money

has been spent and re-spent amounts to 250m or 2.5

times the original government spending of 100m.
With example of an economy, any injection would
contribute 2.5 times its amount to national income.

Formulas
MPC=Marginal Propensity to Consume
MPW=Marginal Propensity to Withdraw
MPW=Marginal Propensity to Save (MPS) +

Marginal Rate of Taxation MRT + Marginal

Propensity to Import MPM or
MPW=MPS+MRT+MPM
1
1
1
1-MPC or

MPS+MPM+MRT =

MPW

Elasticity
How large an effect will the multiplier have?
Depends on the elasticity of supply.
If there is plenty of spare capacity in an economy

then the supply will be far more elastic and that will
mean a larger effect.
If we are close to full capacity with an inelastic PES

then the multipliers effect lessens.

Example Questions
Work out the National Income increase of these 3

different economies if 50 million dollars is invested

in each.
Country A has an MPC of .75
Country B has an MPC of .80
Country C has an MPC of .50
In which country would the greatest degree of GDP
increase take place?

Withdrawals
Work out the National Income increase of the

economy below if 100 million dollars is invested and

its MPW is as follows:
MPS=0.2
MPT=0.3
MPM=0.3