Multiplier effect

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The multiplier effect is the effect of an injection of income into an economy upon the total income of that economy. It is a definitional consequence[1] of the circular flow of income model of the economy. The effect is to raise the total income of the economy by a multiple of the initial injection. The magnitude of the effect is limited by "leakages" from the injected income into, for example, taxation or spending on imports. If the recipients of the increases in income would otherwise be unemployed, the effect takes the form of an increase in the level of activity in the economy. If they would otherwise be fully employed, it takes the form of an increase in the general level of prices.

The basic spending multiplier model embodies the implicit assumption that income leakages are a fixed proportion of the initial injection, and that the multiplier is consequently invariable. They assume, for example, that a community's marginal propensity to save is a behavioural constant. More sophisticated models take account of the effect upon behaviour of the perceived permanence or otherwise of the income injection. Robert Barro has argued that the multiplier effect of an increase in public spending is zero because taxpayers save an equivalent amount in anticipation of a subsequent tax increase[2]. The multiplier effect may also be influenced by changes that are associated with the initial injection. It has been argued that interest rate increases caused by government spending cause an offsetting "crowding out" of private sector investment [3]. The multiplier effect may also be influenced by the state of the economy at the time of the injection. Following the bursting of an house price bubble, for example, households may use additional income to repay debt instead of spending it.

In the context of fiscal policy the initial injection of income may take the form, either of an increase in public expenditure, without a balancing increase in taxation, or of a reduction in the revenue from taxation without a balancing reduction in public expenditure. In either case it is met by borrowing and involves an increase in the government's budget deficit. Correspondingly, the multiplier effect operates to reduce total income when fiscal consolidation action is taken to reduce the budget deficit.

Fiscal policy is normally concerned with the effect of upon output of changes in the budget balance, and that depends upon how far the economy is from full employment. (As already noted, if all recipients of income were fully employed, the multiplier effect would be confined to an increase in the general level of prices, with no effect upon output.) When the term "multiplier" is used without qualification to denote a numerical value, it is the effect upon the "real" (inflation-corrected) value of output that is normally referred to. Also, the numerical values quoted normally refers to the first-year effect of the policy change. Most estimates of the magnitude of the multiplier, so defined, have been in the range of 0.4 to 1.2, but multipliers have been found to be larger than average during periods of economic crisis[4]. The policy implications of such multiplier estimates are examined in the article on the fiscal multiplier.