Multiplier Effect

What It Means

In an economy the multiplier effect occurs when government spending spurs an expansion in economic activity, which in turn promotes further spending by consumers and private businesses. In one sense government spending is designed to provide society with things it needs, such as highways, bridges, schools, and financial assistance programs for the poor. At the same time, government spending also creates jobs by hiring private businesses to undertake various government-funded construction projects. These businesses must hire workers, who use a portion of their earnings to pay for various goods and services. In turn, the companies that produce these goods and services experience an increase in their business, which prompts them to hire new workers. These workers spend their wages on other goods and services, and so on. In other words, when government spending leads to widespread increases in consumer spending, the impact on the economy is known as the multiplier effect.

When Did It Begin?

The concept of the multiplier effect was first introduced by British economist John Maynard Keynes (1883–1946). In the years following World War I, Keynes developed an economic theory that emphasized a balance between the private sector’s freedom to conduct business and government’s role as a stabilizing force in the economy. (The private sector is that part of the economy not controlled by the government.) Keynes believed that government intervention in the economic process, particularly in the form of spending programs, was sometimes the best method of ensuring economic growth and stability. In order to illustrate the role of government spending in economic expansion, Keynes developed the idea of the multiplier effect, which he outlined in detail in his 1936 book The General Theory of Employment, Interest, and Money.

The “Keynesian multiplier” was the term economists first used to denote the multiplier effect. The term described the effect on the demand for goods and services of any increase in spending coming from outside of business production, including increased government spending. Ultimately government spending goes to people who use it to purchase goods and services. More spending means that more workers are needed to produce goods, so employment levels rise and wages and consumer spending increase, which provide the economy with needed stimulus. Economists who support Keynesian theories believe that it is the government’s role to correct the economy’s irregularities.

More Detailed Information

Many economists consider government spending to be an effective means of stimulating growth during periods of economic stagnation. Most of the time, an economy is driven by private investment—that is, by the money that individuals, companies, and other entities pay to businesses in order to help them grow. When private investment decreases, however, companies are unable to expand, and the overall economy ceases to grow; in some cases the economy may actually decrease in size. Confronted with a lack of private investment, a government might try to prevent economic contraction through its own spending. While the government typically spends its money differently than private investors, devoting funds to government-related projects rather than investing them directly in private businesses, the end results of the spending can be similar. So long as the government spending prompts an increase in aggregate demand (the term for overall demand for goods and services within an economy), then the economy will see increased spending on goods and services. In principle, then, the multiplier effect has the potential to create a cycle of growth, in which spending spurs economic activity, which leads to continued spending, and so on.

For example, imagine that the government decides to spend $10 million on a new bridge. The government will hire a private construction company, which will use the $10 million to purchase equipment and hire workers. In this arrangement two companies have enjoyed an increase in revenue: the construction company, as well as the company that sells the equipment. Now, imagine that the company that manufactures the equipment saves 10 percent of its earnings while investing the other 90 percent in expanding its production capacity. At the same time, assume that the construction workers on the bridge project spend 90 percent of their earnings on food, clothing, electronic equipment, and leisure activities. If 10 percent of the original $10 million goes into savings, then $9 million is being spent on materials and new workers (in the case of the equipment manufacturer) and consumer goods (in the case of the workers). This $9 million has been distributed to a wide range of businesses and individuals. If all of these businesses and workers adhere to the same formula (saving 10 percent of their earnings while spending 90 percent), then they will eventually be putting $8.1 million back into the economy. The businesses and workers who receive the $8.1 million will eventually spend $7.29 million. The growth created by the government’s initial $10 million expenditure, in other words, multiplies throughout the economy.

In light of this scenario, the growth in consumer spending caused by the multiplier effect depends to a large degree on the average rate of savings among businesses and consumers. In Keynesian economics the proportion of earnings that an individual is willing to spend is known as the marginal propensity to consume (MPC). If consumers feel uncertain about the economy, they might be more inclined to save 50 percent of their earnings rather than 10 percent. This high level of saving would have a dramatic effect on consumer spending, which would subsequently slow overall growth in the economy. For this reason economists often discuss the multiplier effect in terms of a ratio between consumption and savings.

Recent Trends

Although economic growth in the United States had already begun to slow by the beginning of the twenty-first century, the terrorist attacks of September 11, 2001, made matters dramatically worse. The stock market (where shares in companies are bought and sold) was suspended for several days, global trade was disrupted, and a number of businesses (notably in the airline industry) were forced into bankruptcy. In the final months of 2001, consumer spending slowed considerably.

Not long after the terrorist attacks, President George W. Bush and the U.S. Congress decided to implement several new government spending measures, nearly half of which were designated for military and national security purposes. In 2002 and 2003 federal spending grew at an average rate of 7.6 percent, more than double the average rate of spending between 1993 and 2001, when it rose only 3.4 percent a year. Although this rise in government spending prompted harsh criticism from a number of fiscal conservatives (who are generally opposed to high levels of federal spending), many economists believed that the increased funding helped salvage the economy during an otherwise uncertain period. These economists argued that, by bolstering the defense and security industries, the government prompted a cycle of spending that helped contribute to continued economic growth.