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Definition:
The number of times the final change in income is greater than the initial
change in injection that caused it.

A) THE INVESTMENT MULTIPLIER

(2 sector multiplier)
 Definition:
→ The number of times the final change in income is greater than the initial
change in INVESTMENT.

 Formula:
→ Multiplier, k =

Multiplier Concept:
- Emphasizes that changes in investment can generate substantially greater
changes in income and consumption. (Consumption will expand with a growing
income)
 E.g: Autonomous investment has a multiplier effect in stimulating increase in
income and inducing increase in consumption spending.

↑ Auto Imultipliereffect
→→ ↑ Y →→→ ↑ C
[↑ Y > ↑ I] Induced by income.
C = f(Y)
 A normal multiplier:
→ Operates in times of high economic activity/boom.
→ i.e. autonomous investment Y C
C= f(Y)

 DOWNWARD multiplier/ multiplier in REVERSE:

• Operates in times of recession/low economic activity.
e.g. cancellation of investment projects, closure of factories
• i.e. auto I Y
induced C
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The Multiplier process – a general explanation

o The multiplier process is based on the the principle that ‘one man’s
spending is another man’s income’.
o When extra spending is injected into the economy, it will then
stimulate further spending, which in turn will stimulate yet more
spending and so on…
Example:
o If firms decide to invest more, this will lead to more people being
employed and hence, more incomes being paid to households.
o Households will then spend part of this increased income on
domestically produced goods (the remainder will be withdrawn, i.e. leakage

saved, pay taxes, buy imports). This increased consumption will

encourage firms to produce more goods to meet the demand.
o Firms will employ more people and other factors of production. This
leads to even more incomes being paid to households.
o Consumption will thus increase yet again and the process continues…
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The Multiplier Model:

o To demonstrate the multiplier process.
o The multiplier process is based on the the principle that ‘one man’s
spending is another man’s income’.
o When extra spending is injected into the economy, it will then
stimulate further spending, which in turn will stimulate yet more
spending and so on…

Assumptions:
o 2 sector model.
o Unemployed resources in the economy. Why? (at full employment,
inflation will take place )
o Assume:
mps = 0.2 mpc = 0.8 k = 1/mps = 1/0.2 = 5
o Autonomous injection of $100million through investment.
i.e. I = $100m

Table:

ROUND CHANGE IN Y CHANGE IN C CHANGE IN S

1 $100m $80m $20m

2 $80m $64m $16m

3 $64m

Explain Table:
Chain of causation: Multiplier
o Firms I by $100m. Sales revenue in I g/s $100m. These will be
used to pay out as factor payments to those who supply the
resources to produce capital goods.
Therefore change in spending generates $100m in Income (NY) in
Round 1.
[The injection of $100m through investment will increase national
income (NY) in the economy by $100m in Round 1.]
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o Now households have $100m in income.

Out of this $100m, with mps = 0.2 and mpc = 0.8, their change in C
spending will be 0.8 × $100 = $80m.
Therefore now, their change in savings is $20m and change in
consumption spending is $80m.
o Based on the idea that ‘1 man’s spending is another’s man income’,
the change in consumption spending of $80m will, in the next round
change national income (NY) by $80m. (Round 2)
o Out of this, change in consumption is $64m, change in savings is
$16m, with mps =0.2and mpc=0.8, the process continues with an
infinite increase in income in the economy. (Round 3)

o HOWEVER, through the process, there will be leakages through

savings (S), which weakens the multiplier size after each round of
spending.

o In example, the economy reaches a new level of NY with an

increase of $500m.

o FINAL EFFECT will be:

To find change in Y:
Use Multiplier formula: k = ∆ Y
∆ I

Therefore ∆ Y = k x ∆ I

In example, ∆ Y = 5(100m)
= $500m

Note: Each round of extra income is smaller than the last, because households
save. In the end, the FINAL increase in income is BIGGER than the INITIAL
increase in spending.
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Diagram/graph to illustrate the multiplier process:

Expenditure
Y(AS)

AD2=C+I+I2 ($100m)
E2

Autonomous Injection Y ($500m)

($100m)
AD=C+I

E1

Y1
Income (Y)
Y2

$500m)

B) THE EXTENDED MODEL

So far, we have only considered the Investment multiplier, in a 2 sector model:
Now, to see what happens when we introduce: i) The government sector
ii) The overseas sector

i) The Government Sector

• Government spending (G) – infrastructure, public/merit goods, subsidies etc.
• Taxation (T) – Direct Tax
- Indirect Tax

TOTAL SPENDING = C + I + G
(3 sector)
* Government spending will have a multiplier effect if G > T, i.e. ↑ G →→ ↑ Y → ↑ C
multip

Govt. spending multiplier, k = 1/mpt OR k=1/mrt(marginal rate of tax)

*Note: TAXATION is a LEAKAGE to the government spending multiplier.

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ii) The Overseas Sector

• X (Receipts from exports) – INJECTION
• M (Payment from imports) – LEAKAGE

 TOTAL SPENDING = C + I + G + (X-M)

(4 sector/open economy)

multip
* Exports will have a multiplier effect if X > M, i.e. ↑ X →→ ↑ Y → C
Foreign trade multiplier, k = 1/mpm

*Note: IMPORTS is a LEAKAGE to the foreign trade spending multiplier.

C) THE COMBINED MUTLIPLIER

 Takes into account ALL INJECTIONS.

(I, G, X)

Combined multiplier, k = 1/mps+mpt+mpm = 1/marginal rate of leakages

(open economy multiplier)

Reasons for the Multiplier Effect:

 All injections (I, G, X) are subject to the multiplier effect.

 The multiplier of I, G and X rises from the fact that these expenditures do not put
additional goods and services on the market for sale to consumers.
E.g: I is spent on capital goods.
G is represent government spending.
X represents goods and services bought overseas.

 Each of these sources of increase in the money flow has a counter-part which causes a
leakage of money from the flow.
E.g: S compensates for I.
T compensates for G.
M compensates for X.

 So that if I + G + X = S + T + M, there will be EQUILIBRIUM in the circular flow

and there would be no inflation, nor the multiplier effect.
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The Multiplier in the OPEN ECONOMY (4 sector)

ALL INJECTIONS (e.g. I, G, X) are subject to the multiplier effect in
stimulating increase in INCOME (↑ Y) which in turn induces increase in
CONSUMPTION SPENDING. (↑ C)
 Definition of multiplier:
• The no. of times the final change in income is greater than the initial change in
injection that caused it.

 Formula:
• Multiplier, k = 1/marginal rate of leakages
1/mps+mpt+mpm
 Multiplier model:
Assumptions
o Open economy.
o Unemployed resources.
o mps = 0.2, mpt = 0.1, mpm = 0.2
o
 mpc = 1-(mps+mpt+mpm)
=0.5
k = 1/mps+mpt+mpm
=1/0.5 =2
o There is autonomous injection of $100m through investment expenditure.
i.e. I = $100m

Table

ROUND CHANGE IN CHANGE IN CHANGE CHANGE IN CHANGE IN

Y C IN S T M
1 $100m $50m $20m $10 $20

2 $50m $25m $10m $5m $10m

3 $25m
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Explain Table
o If firms decide to invest $100m, the economy will produce $100m worth of
output.
o Firms I by $100m. Sales revenue in I g/s $100m. These will be
used to pay out as factor payments to those who supply the
resources to produce capital goods.
Therefore change in spending generates $100m in Income (NY) in
Round 1.
[The injection of $100m through investment will increase national
income (NY) in the economy by $100m in Round 1.]
o Households will then spend part of this increased income on
domestically produced goods [C], part of this may saved [S] ,pay
taxes [T], and buy imports[M]. This increased consumption will
encourage firms to produce more goods to meet the demand.
o Firms will employ more people and other factors of production. This
leads to even more incomes being paid to households.
o Consumption will thus increase yet again and the process continues…
o The resulting Round 2 of expenditure is reduced by these leakages
of (S, T, M) from the circular flow.
o Each time the additional increase in spending and income is a fraction
of the previous addition to the circular flow.
o The process repeats itself for every round of expenditure.

o The FINAL EFFECT will be:

Use Multiplier formula: k = ∆ Y

∆ I

Therefore ∆ Y = k x ∆ I

In example, ∆ Y = 2 x $100m =$200m

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expenditure
Y(AS)
AD2=C+!+G+(X-M)

mult
AutoI ------> Y ---> C
($100m)
AD=C+I+G+(X-M)

E1

income (Y)
Y1

Limitations of the Multiplier:

1. Works when injections are greater than withdrawals/leakages.
(J > W)

2. Leakages weaken the size of k (the multiplier).

3. Works when resources are underemployed. If full employment, will lead to

INFLATION.

4. Subject to changes in government policy and economic climate.

5. Calculations of k subject to human error in forecasting and other variables

leading to a policy which may be too expansionary or not expansionary enough.

6. Time lag – time taken between identification of problem, formulation of policies

and implementation of policies. By the time the policies are ready for
implementation, the economy may have moved on to another phase of the
business cycle.