What is the Multiplier Effect?

The multiplier effect is like the way a disruption moves through an ecosystem…

If an ecosystem is in balance, the food chain stays stable. But imagine something disrupting just one of the animals. For example, say that a disease kills half of the wolves in a region. The impact of that disruption goes beyond the number of wolves that remain. Fewer wolves might mean fewer deer are hunted. The larger deer population might result in more grazing, which decreases the amount of plant life. With fewer plants, maybe rabbits become easier to spot for hawks. The implications of a shock to a system extend far beyond the initial change.

The multiplier effect is a core concept in macroeconomics, especially the Keynesian economic theory. It is the idea that because of the flow of money, an increase in wealth will pass through many hands. Therefore, the implications of additional money extend beyond the person that first receives it. That person might leave it as a tip for a server, who gives it to a babysitter, who gives it to a grocery store, who pays it to someone stocking shelves, and so on.

In macroeconomics, two types of government interventions affect the economy. Each has a multiplier effect attached to it. First, the government can increase aggregate demand (the total amount of products purchased in an economy) through expansionary fiscal policy (increasing how much it spends). Perhaps the government gives everyone $1,200 checks. When that happens, the impact on the economy is more significant than it might appear at first. These additional effects are due to the fiscal multiplier — Which refers to the number of times that the increased government spending circulates.

A different type of multiplier occurs when a central bank increases the money supply. That results in banks loaning that extra cash to people. When those borrowers make purchases, the money ends up back in the bank to be loaned again. This process of lending money multiple times puts more money into circulation than exists. This process is called the money multiplier.

Economists use models to estimate the net impacts of a change in the economy. In the case of economic multipliers, the most common tool is called an input-output model. This model attempts to correlate activities across industries, which then allows a change in one sector to flow through every other sector.

For example, if a $1M government project gets funding, the model spreads that $1M across the sectors that receive that money. Perhaps the construction industry receives $650,000. Then, the construction industry pays $500,000 to construction workers, who, in turn, spend $400,000 on retail products. That $400,000 flows down to wholesalers, farmers, and retail workers. In this way, the initial capital spend flows through the economy, impacting sectors far removed from the direct recipients of the funding.

In the financial sector, economists estimate the money multiplier using the required reserves ratio. The United States Federal Reserve once required that banks hold at least 10% of certain deposits in reserve. That meant that a bank could loan a maximum of 90% of the money it borrowed from depositors. But if one person borrowed $10,000 to purchase a car, the seller of the car ended up with $10,000 that goes into the bank. As a result, any money that got loaned out would end up back in the bank as a deposit — Of which, 90% could go out as another loan.

In theory, that implies that the money supply could have been expanded by 10 times more than an original deposit. However, a model using this assumption (called a reserves-first model) doesn’t capture the fact that banks are not required to loan out 90% of their deposits. Therefore, the actual multiplier may be less.

An alternative model (called a loans-first model) starts with the banks deciding how much they are willing to loan, and then seeking required reserves to support that volume. The reserves-first model was the mainstream approach taught in economics textbooks for many years. The loans-first model is a newer concept that seems to fit the current data better.

To calculate the size of the multiplier, you must know how quickly money leaves an economy. There are several ways that money stops circulating. Taxes, imports, and savings are the most common examples. All of these factors result in cash leaking out of the regional economic system.

For simplicity, economics textbooks focus on the saving versus consumption of household income. The percentage of income a person spends is called the marginal propensity to consume (MPC). Everything that is not spent is saved. That percentage is called the marginal propensity to save (MPS). Using these concepts, the formula for an economic multiplier is simple:

Economic Multiplier = 1 / MPS

As an example, assume that people have a MPS of 10%.

After just 10 rounds following this $100 injection, it has created $586 of economic growth. If we look out to 50 iterations, all of the money will have finally leaked out. But it will have generated $900 of increased economic activity — plus the original $100 injection. With a 10% leakage rate, the money creates 10 times more business than the initial injection.

The money multiplier is determined by a required reserve ratio set by the central bank.

Money Multiplier = 1 / required reserve rate

For instance, if a central bank requires a reserve rate of 20%, the money multiplier would be 5.

Money Multiplier = 1 / 0.2 = 5

That means that if the central bank buys $1T worth of securities from banks, it could result in the money supply increasing by up to $5T. With no required reserve ratio, the money multiplier is theoretically infinite.

When money gets injected into an economy, three stages increase the amount of economic activity that results.

The first-order effects of an injection are what is directly visible. For example, a government stimulus check of $1,200 per person will obviously increase the income of everyone receiving that check. That is the direct impact, and it is easy to understand.

But the stimulus check doesn’t stop with the people who get the money. They go out and spend it, which leads to increased consumer spending. If people use their stimulus check to go out to eat, that might cause restaurants to hire more cooks and waitstaff. These are the second-order impacts of the initial injection.

But the money doesn’t stop there either. Those additional waitstaff end up with more income than they previously had. And they are likely to spend it. Perhaps they use that money to buy groceries, go to the movies, and put gas in their cars. Consequently, the grocery store, movie theater, and gas station see an increase in revenues. These are induced impacts that flow from that initial injection of cash.

The major criticism of multiplier models is that they do not tend to align with empirical data. Therefore, elected officials may not be able to point to the success of a project that they promise. That is partly because the second and third-order effects of a stimulus might take years to appear. And other changes to the economy can happen concurrently, making it challenging to identify the results.

Other criticisms include the potential for government spending to crowd out other investment, and the lack of consideration of where the increased spending comes from. Higher taxes to pay for increased spending results in an economic multiplier in the other direction. Borrowing the money leads to a greater national debt. These other impacts can offset the stated benefits of fiscal policy, sometimes to the point that it makes things worse.