Spending multiplier

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In economics, the spending multiplier effect describes a process by which an initial increase of one economic aggregate is amplified and provokes an increase in the same or/and other aggregate(s) larger than the initial raise. The idea is that the raise of a first agent income improves the situation of a second agent by the way of consumption, and so on.

The spending multiplier is a key concept in Keynesian economics for it explains how the government purchases can have a strong stimulating effect on the national output, depending on the marginal propensity to consume.

Example in an closed economy

Consider a closed economy in which private agents consume in average 80% of their income. If the government increases its purchases by 100, then the national output will increase by 500.

Agent Consumption Saving
Government 100 0
Through consumption, the government increases by 100 the income of one of its suppliers (agent #2).
#2 80 20
Agent #2 saves 20% of his new wealth and spends the remaining money, increasing by 80 the income of agent #3.
#3 64 16
#4 51 13
#5 41 10
#6 33 8
#7 26 6
... ... ...
Total 500 100

In mathematics, this result is known as the sum of a convergent geometric serie.

An other demonstration relies on the following accountant relation in a closed economy :

Income = Consumption + Investment
Income = Private Consumption + Governmental Consumption + Saving - Taxes
Y = C + G + I - T
Since C = cY with c the propensity to consume, then
Y = cY + G + I - T
(1-c)Y = G + I - T
Y = (G + S - T)/(1-c)
Thus, an increase of G by 1 implies an increase of Y by 1/(1-c).

Influence of imports in an open economy

Agent Consumption of domestic products Imports Saving
Government 100 0 0
Through consumption, the government increases by 100 the income of one of its suppliers (agent #2).
#2 60 20 20
Agent #2 saves 20% of his new wealth and spends the remaining money. Because of imports, only three quarter of his purchases increase the income of another domestic agent. Thus agent #3 receives 60 instead of 80.
#3 36 12 12
#4 21,6 7,2 7,2
#5 7,8 2,6 2,6
... ... ... ...
Total 250 50 50
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