Lesson preview · Multiplier Effect
The Multiplier Effect
~14 min · Free to read
The government hires a road crew and pays them 100 dollars. That looks like 100 dollars of new spending. But the story does not stop there. The road workers take their 100 and spend most of it — on groceries, rent, a night out. Now the grocer and the landlord have extra income, and they spend most of that. Round after round, the same 100 keeps changing hands.
Each round is smaller than the last, because people save a slice of every dollar they receive. But the rounds add up. By the time the dust settles, that first 100 dollars has lifted total spending by far more than 100. This is the multiplier effect: one dollar of new spending raises GDP by more than a dollar.
Key Term
MPC and MPS — what people do with an extra dollar
When income arrives, you split it two ways: spend some, save the rest.
- Marginal propensity to consume (MPC) — the fraction of each extra dollar of income that people spend. If MPC is 0.75, people spend 75 cents of every new dollar.
- Marginal propensity to save (MPS) — the fraction they save. If MPC is 0.75, then MPS is 0.25 — they save 25 cents of every new dollar.
There is nowhere else for the dollar to go, so the two fractions always add to one: MPC + MPS = 1.
The size of the multiplier depends entirely on the MPC. The more of each dollar people re-spend, the longer the chain runs before it peters out — and the bigger the total. A single formula captures it.
The spending multiplier. It says how many dollars of total GDP one dollar of new spending eventually produces.
Notice the lever: the multiplier rises with the MPC. If people re-spend 80 cents of every dollar (MPC 0.8), the multiplier is . If they re-spend only half (MPC 0.5), it is . The more leaks out into saving each round, the sooner the chain dies, and the smaller the total.
Tip
So what
That is the multiplier in one picture: the higher the fraction people re-spend, the longer the cascade runs and the more total GDP one injection produces.
Key Term
The paradox of thrift
For one household, saving more is plainly sensible — it builds a cushion. But suppose everyone tries to save more at the same time. A higher MPS means a lower MPC, which shrinks the multiplier. Each dollar of income now triggers fewer rounds of spending, so total spending — and total income — falls. People end up earning less, and may save no more in dollar terms than before.
This is the paradox of thrift: an action that is wise for one person can be self-defeating when a whole economy does it at once, especially in a slump.
Worked Example
The government injects 100 dollars of new spending. The marginal propensity to consume is 0.75. (a) Find the marginal propensity to save and the spending multiplier. (b) Find the total rise in GDP. (c) How does the answer change if a wave of fear makes households cut their MPC to 0.5?
Trap · Common Misconception
"The multiplier creates money out of nothing"
The multiplier is not magic and it is not infinite. Each round is strictly smaller than the last, because people save a slice of every dollar. The rounds form a shrinking series that adds up to a finite total — 100 dollars at MPC 0.75 reaches 400, not infinity. Nothing is conjured from nowhere: the same dollars simply change hands many times, and counting each transaction is what makes the total larger than the original injection.
Check yourself · no marks
Two economies each get a 50-dollar spending injection. In economy A the MPC is 0.8; in economy B it is 0.6. Which economy sees the larger total rise in GDP, and by how much?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 4
If the marginal propensity to consume (MPC) is 0.75, what is the spending multiplier?
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