Multiplier Effect - Explained
What is the Multiplier Effect?
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Table of ContentsWhat is the Multiplier Effect?How Does the Multiplier Effect Work?Reserve Requirement Money Supply and the Multiplier EffectAcademic Research on the Multiplier Effect?
What is the Multiplier Effect?
The multiplier effect is a term used in economics according to which the national income increases with more money spent. It also means that capital investment, be it at the public or organizational level, has a snowball effect on the economic condition of a country. When a new project or activity occurs, it creates more employment opportunities, leading to more disposable income, increase in disposable income, increase in demand for goods and services, boosts the sellers disposable income, etc. To summarize, the money spent by one becomes income of the other.
- As per Keynesian economic theory, aggregate demand can have a huge impact on the economic growth of a nation.
- The multiplier effect considers the impact that a change in aggregate demand will create on final economic condition.
- While figuring out the spending multiplier, the percentage of the injection that needs to be kept separate as leakages should be ascertained. Leakages include savings, taxes and imports. The amount left is used for consumption purposes, and this remaining amount is referred to as marginal propensity to consume.
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How Does the Multiplier Effect Work?
A significant point made in Keynesian economic theory states that aggregate demand can influence economic activity of a nation. Considering the marco effects, the multiplier effect ascertains what impact the change in aggregate demand will create on the economic growth. Multiplier is calculated by dividing the change in real gross domestic product (GDP) with changes made in injections such as government expenditure, reducing or increasing tax rates and/or interest rates, exports, etc. While we ascertain the spending multiplier in an open economy considers the percentage of the injection kept separately for leakages including savings, taxes, and imports. The left amount, known as the marginal propensity to consume (MPC), will be something that is used for consumption. For a better understanding, lets keep all three elements at 15%. Multiplier = 1 / (savings + taxes + imports) = 1 / (0.15 + 0.15 + 0.15) = 1 / 0.45 = 2.22 So, this states that an expenditure of $1 would affect or impact the gross domestic product by 2.22. The multiplier effect can have a negative impact too. Say, decline in spendings may cause more unemployment, more reduction in aggregate demand and lesser GDP. The banking system of a country clearly exhibits the multiplier effect. When banks start lending more, it leads to increasing the money supply of the nation. The proportion of deposited funds that banks need to keep as reserves affect the size of the multiplier. This is the amount of money that results in creating more money, and can be ascertained by dividing total bank deposits by the requirement of reserves. For instance, a bank is required to keep 20% reserves for every $100 deposited by the customer. This 20% translates to keeping $20 reserves for every $100. And, the bank can use the remaining amount of $80 for issuing loans to other customers. Usually, customers further deposit this amount of $80 in some other bank, which again needs to keep 20% or $16 of the amount as reserves, and lending the remainder of $64. This process keeps on going as there are more deposits made by people, and banks keep using this deposited amounts for lending purposes. It continues until the deposited amount of $100 converts to $500 as deposits.
The reserve requirement is regulated by the board of governors of the Federal Reserve System. The percentage depends on the total liabilities that a specific depository institution or a bank holds. For instance, institutions having a minimum of $110.2 million deposits had to keep 10% of their total liabilities as reserves.
Money Supply and the Multiplier Effect
The money supply is made of many levels. Monetary base, the first level in the chain, represents all of the physical currency that is being circulated in the economy. M1 and M2 are the other two levels that add the balances lying in deposit bank accounts, and the ones dealing with time deposits and money market shares respectively. When a customer deposits money into an M1 deposit account, the bank sets aside a reserve from that amount, and lends the remaining amount to another customer. The person who makes a deposit is indeed the owner of that initial amount deposited. However, these funds that lend money to another customer enable in creating more funds. When a borrower makes a subsequent deposit of the money that he/she obtained as a loan from the bank, it will add to the value of M1 no matter if there is no marginal physical currency present for supporting this new transaction. The more the reserve requirement, the more stringent will be the money supply. This situation leads to a lesser multiplier effect for each dollar deposited. This may negatively affect the lending capacity of financial institutions due to lesser options owing to the reserve size. On the other hand, the lesser reserve requirement signifies more money supply, stating that there is more money generated for each dollar deposited. This scenario enables banks to take more risks with a bigger basket of present funds.