Multiplier Effect

Changes in Government Purchases There are two macroeconomic effects from the change in government purchases: The multiplier effect The crowding-out effect

Multiplier Effect It is defined as an effect in which an increase in spending produces an increase in national income and consumption greater than the initial amount spent The size of the multiplier depends upon household’s marginal decisions to spend, called the marginal propensity to consume (mpc), or to save called the marginal propensity to save (mps).

Example For example, if a corporation builds a factory, it will employ construction workers and their suppliers as well as those who work in the factory. Indirectly, the new factory will stimulate employment in laundries, restaurants, and service industries in the factory's vicinity.

Example For example, if 80% of all new income in a given period of time is spent on products, the marginal propensity to consume would be 80/100, which is 0.8.

Formula The following general formula to calculate the multiplier uses marginal propensities, as follows: 1/1-mpc Hence, if consumers spend 0.8 and save 0.2 of every Rs.1 of extra income, the multiplier will be:                 1/1-0.8                 = 1/0.2                 = 5 Hence, the multiplier is 5, which means that every Rs.1 of new income generates Rs.5 of extra income.

Crowding Out Effect A situation when increased interest rates lead to a reduction in private investment spending such that it dampens the initial increase of total investment spending is called crowding out effect