How to Calculate the Multiplier Effect (With Example)
By Indeed Editorial Team
Published 26 April 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
The multiplying effect in economics can tell you about the proportional relationship between the additional allocation of extra funds and the increases in revenue. This effect represents the changes that revenue experiences because of vital injections into the economy. This value can also help organisations and businesses determine how to position services and products and establish employee compensation to create ongoing growth in both businesses and the entire economy. In this article, we explain what the multiplier effect is, discuss how it works in business and macroeconomics, and outline how to calculate it with an example.
What is the multiplier effect?
The multiplier effect, or Keynesian effect, refers to how an initial injection of funds into the circular flow of income can boost economic activity in excess of the initial investment. The effect compares the increases in revenues to the changes in the cash flow that caused the increase. The expenses that influence this increase in income represent injections that occur because of the economic cash flow from financial activities like economic spending, exportation revenues and corporate investments. For instance, if the government invests $500 million into a new infrastructure project, the funds go to the companies that pay their employees.
When injections take place, the additional revenue can result in increased spending, thereby creating more revenue streams. The multiplier may also be useful to many professionals who analyse and predict financial outcomes. To calculate the multiplier, you can use the following formula:
Multiplier = Change in income / Change in spending
How does the multiplier effect work?
The multiplier or Keynesian effect states that the final income for a company or economy increases when there are new injections for projects or large-scale expenses. Injections are monetary additions to an economy or organisation, such as corporate and government spending. Also, the multiplier depends on both saving and spending activities within an economy, where saving represents the marginal propensity to save (MPS) and spending represents the marginal propensity to consume (MPC).
Since these activities are consumption-based, identifying the multiplier in these instances requires MPC. This effect causes similar changes to economic and business income and spending, but it can have more complexity on a macroeconomic scale. Consider how the multiplicative effect works in both economic and business environments:
Multiplicative effect in macroeconomics
When consumer demand and national revenues increase, this means organisations, corporations and other entities produce more services and goods to meet the demand. This can result in additional income due to the continuous operations to meet consumer demand. This ultimately causes the revenues of economies to increase beyond consumer and national spending.
You can use the above formula to calculate the multiplier on an economic scale, but there are several factors that are integral to understanding the propensity of consumption value of an economy. When an entire economy determines the marginal propensity to save, factors like export revenues, import investments and taxation are necessary for assessing the MPC accurately.
Multiplicative effect in business
In business, the multiplier represents an injection or increase to financial spendings, such as company stock investments and employee bonuses. For example, when an organisation compensates employees with a raise or bonus, this injection of employee income can then cause changes in economic spending. When the company's employees spend the additional income within other businesses, this causes increases to other revenues and wider opportunities for employment.
How to calculate the multiplier
Here are the steps you can take to calculate the multiplier:
1. Determine the marginal propensity of consumption
Calculate the MPC to apply the multiplier formula. The multiplier ultimately depends on the ratio of saving to spending per every dollar a company or the economy generates. Thus, if consumers spend $0.15 per dollar they earn, this gives you a marginal propensity to consume of 0.15 / 1 or just 0.15. On an economic scale, other marginal values go into the MPC calculation, including marginal exportation, importation and taxation. For instance, you can apply the multiplier formula using an MPC value of 0.15:
K = 1 / (1 - 0.15)
2. Subtract the MPC from one
When you determine the marginal propensity of consumption, make sure to subtract it from one. Using the example value of the $0.15 consumers spend for every dollar they earn, subtract it in the formula. Here's what it looks like:
K = 1 / (1 - 0.15) =
K = 1 / (0.85)
3. Divide the difference and one
To find the K value, divide one by the difference you get from subtracting the MPC and one. This results in the multiplier. Using the example values, complete the equation:
K = 1 / (0.85) = 1.18
4. Evaluate the result
The multiplier value represents the factor that causes increases in revenue relative to the consumption of services and products. You can use this value to understand the rate of change between each factor and display this data on a graph or chart. When evaluating the multiplier, you can observe the increases in growth, consumption and revenue relative to additional cash flow through injection. Thus, multipliers that are greater than one indicate that the increase in income or revenue is greater than the spending or other injections that caused the initial increase.
Types of multipliers
Here are the different types of multipliers:
An employment multiplier, also called a jobs multiplier, measures the amount of direct, indirect and induced jobs lost or created in an area. It indicates how important an industry is in regional job creation. An employment multiplier of three, for instance, might mean that for every job created by that industry, two other jobs may be created in other industries.
A sales multiplier shows how well established an industry is in your region. For instance, a highly developed cluster may have a high sales multiplier, as every dollar fed into the cluster from the outside has a high ripple effect. This effect can propagate through the regional economy for some time before it leaks out.
For example, one dollar of sales coming into a highly developed automotive manufacturing cluster may have a ripple effect of 3.8. In other words, the dollar led to a total of $3.80 in regional sales. Clusters and industries with very low multipliers are often owned outside of the region and also buy mostly from outside the region.
The concept of the earnings multiplier is one of the primary principles of Keynesian economics. Also called income multiplier, earnings multiple refers to the theory that a dollar spent can turn into more money. For example, if a company pays an employee $60,000, they may spend that money in various places. Those places then re-spend that money on utilities, inventory and more employees. Those employees then spend their income and on and on. The general guideline is that a dollar spent in the economy can create six dollars worth of economic activity.
The spending multiplier, also called fiscal multiplier, is an economic measure of the effect that a change in government investment and spending has on a region's gross domestic product (GDP). In other words, it measures how GDP decreases or increases spending in an economy.
The spending multiplier relates inversely to the marginal propensity to save. Hence, if consumers are saving more of their marginal dollars, the multiplier may greatly diminish. That's why governmental organisations often use this to determine the amount of stimulus that's appropriate for the economy. If MPS is higher, consumers may save more and the multiplier decreases. This creates a smaller and less effective stimulus. If consumers save less and spend more, the multiplier may increase and create a greater stimulus effect.
Example of the multiplier
For this example, assume a corporation wants to understand its proportional changes in income due to changes in injections. If the company gives an additional $0.75 per dollar to employees who complete additional projects, this gives employees extra income to either spend or save. Assuming that employees now spend an additional $0.75 on the dollar, this results in a multiplier effect of:
K = 1 / (1 - 0.75) =
K = 1 / (0.25) = 4
This results in a multiplier of four, resulting in an additional $4 of income for every new dollar the employees spend when shopping, investing and purchasing services from other businesses and organisations. This can cause additional increases in the economy's revenue generation, which then creates more opportunities for employment and organisations to earn income.
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