Multiplier Effect

The multiplier effect refers to the disproportionate rise in final income that results from an injection of spending. In other words, capital infusion, whether it be at the governmental or corporate level, should have a snowball effect on economic activity.

A new project leads to an increase in employment, which leads to an increase in disposable income, which leads to increased demand for goods and services, which increases the disposable income of the seller, and so on. One's spending is another's income.

A key tenet of Keynesian economic theory is the notion that economic activity can be influenced by changes in aggregate demand. On a macro level, the multiplier effect measures the impact that a change in aggregate demand will have on final economic output. Here, the multiplier would be the change in real GDP divided by the change in injections. Injections can include government spending, private investments, exports, lowering or raising tax and/or interest rates.

Calculating the spending multiplier for an open economy entails measuring what percentage of the injection is set aside for "leakages" (savings, taxes, and imports). The remainder is what will be utilized for consumption, often termed MPC (marginal propensity to consume). For the sake of simplicity, we shall set all three at 15%

Multiplier = 1 ÷ (savings + taxes + imports) = 1 ÷ 0.45 = 2.22

So, an injection of spending would change aggregate demand to the extent where GDP would be impacted by a factor of 2.22. In other words, $1 of spending would end up having the impact of $2.22.

The multiplier effect can also work in reverse. For example, sizable spending cuts would lead to higher unemployment, translating to a decrease in aggregate demand and a lower GDP.

The multiplier effect can be seen clearly in a country's banking system. An increase in bank lending should translate to an expansion of a country's money supply. The size of the multiplier depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is the money used to create more money and is calculated by dividing total bank deposits by the reserve requirement.

To calculate this, start with the amount banks initially take in through deposits and divide this by the reserve ratio. If, for example, the reserve requirement is 20% for every $100 a customer deposits into a bank, $20 must be kept in reserve. However, the remaining $80 can be loaned out to other bank customers. This $80 is then deposited by these customers into another bank, which in turn must also keep 20%, or $16, in reserve but can lend out the remaining $64.

Based on the example above, here's what the schedule of deposits/reserves would look like:

This cycle continues as more people deposit money and more banks continue lending it until finally the $100 initially deposited creates a total of $500 ($100/0.2) in deposits.

The reserve requirement is set by the board of governors of the Federal Reserve System and it varies based on the total amount of liabilities held by a particular depository institution. For example, as of 2016, institutions with more than $110.2 million in deposits are required to hold 10 percent of their total liabilities in reserve.

The money supply consists of multiple levels. The first level, referred to as the monetary base, refers to all of the physical currency in circulation within an economy. The next two levels, M1 and M2, add the balances of deposit accounts and those associated with small-denomination time deposits and retail money market shares, respectively.

As a customer makes a deposit into an M1 deposit account, the banking institution can lend the funds beyond the reserve to another person. While the original depositor maintains ownership of the initial deposit, the funds created through lending are generated based on those funds. If the borrower subsequently deposits the funds received from the lending institution, this raises the value of M1 even though no additional physical currency actually exists to support the new amount.

The higher the reserve requirement, the tighter the money supply, which results in a lower multiplier effect for every dollar deposited. This may make financial institutions less inclined to lend as their options to do so are limited based on the size of the reserve. In contrast, the lower the reserve requirement, the larger the money supply, which means more money is being created for every dollar deposited, and financial institutions may be more inclined to take additional risks with the larger pool of available funds.