We all know from school that 2 + 2 = 4. But is this always the case? And here we are faced with such a concept as a multiplier effect. This is an economic term that shows how endogenous variables change in response to shifts in characteristics. The concept suggests that an increase of X by 1% leads to an increase in Y, for example, by 2%.
The concept
The multiplier effect is a concept that is most often associated with how investing in the economy (for example, increasing public procurement) leads to much greater than one might expect growth in employment and the production of goods and services. Let's see how it works:
- There is an investment in the national economy. For example, the state decides to increase procurement.
- Investing leads to an increase in aggregate demand for goods and services.
- This allows firms to more fully load production capacities and hire more workers.
- Employment among the able-bodied population in the country is growing, people are getting more money.
- The aggregate demand for goods and services is growing.
Firms can hire even more workers by loading production capacities.
Calculation
There are several types of multiplier. The most famous is fiscal. They also separately highlight the multiplier effect in monetary policy and in Keynesian models. They talk about it when an increase in some indicators leads to a much larger growth of others. The calculation of the multiplicative effect is always associated with finding the ratio of these changes. For example, the state increased purchases by 1 billion euros. Initially, aggregate demand, as we have said, will also increase by this amount. However, in the end result, it will grow by, say, 2 billion euros. In this case, the multiplier will be equal to 2.
We introduce the following notation:
- Y is the change in real GDP compared to the previous reporting period.
- J is the amount of additional financial injections into the economy.
- M is the multiplier.
We can either take both of the first indicators in monetary terms, or in percentage. Thus, M = Y: J.
Considering what the multiplicative effects are, we already mentioned that this indicator differs in fiscal, monetary and Keynesian models. The formulas are different, although the essence remains the same. It is equal to the quotient of dividing the unit by the marginal saving ability. The formula makes it possible to understand how an increase in the money supply will affect the economy.
Example
Consider how tax reduction affects the economy:
- The economy is developing, the average annual growth rate is positive, and here the state decides to introduce VAT at the level of 15% (given that it was previously higher). Additional investments in the economy are not carried out.
- Disposable consumer income is increasing.
- People get the opportunity to buy more goods, including expensive ones.
- Firms increase production due to an increase in aggregate demand, for which they hire new workers.
- As a result, we have an increase in employment, which means that people will be able to buy even more goods and services.
Monetary multiplier effect
In monetary macroeconomics, the effect of money supply on the general market is being studied. If an increase in the monetary base by 1 dollar leads to an increase in the supply of funds by 10, then the multiplier is 10. Monetarists believe that it is impossible to influence the average annual growth rate through public procurement, which should expand aggregate demand. In their opinion, an increase in the disposable income of citizens leads to the fact that interest on loans becomes larger. And this means a decrease in investment from the business sector, which eliminates the expected multiplier effect.
Monetarists insist on the need to increase money in circulation. The US Federal Reserve does this by changing the reserve ratio for commercial banks. Suppose it is 20%. This means that with every 100 dollars 20 must remain in reserve. The bank can give the remaining money on credit to another. The latter can also take them, having previously deposited 20% of the amount in their reserve account. This happens several times, which triggers the economy, according to the monetarists.
In fiscal policy
This is the most common type of multiplier. It is easiest to understand. It is associated with the actions of the state, which are aimed at increasing aggregate demand. For example, the government may decide to lower taxes. This, as we have already said, will lead to an increase in demand for products, which will allow firms to load production capacities more fully. Another tool of fiscal policy is government procurement.
