Multiplier Effect

The multiplier effect is the idea that one dollar of new spending ends up raising total income by more than a dollar, because each person who receives it turns around and spends part of it. Suppose the government spends $100 paving a campus path. The builder takes that$100 and spends $80 of it at local shops; those shop owners spend part of *that*, and so on. Each round is smaller than the last, but the rounds add up — the total boost to income is well above the original$100.

More precisely, an initial change in autonomous spending — government spending, investment, or exports — leads to a larger change in equilibrium output through successive rounds of induced consumption. How large depends on the marginal propensity to consume (MPC): the fraction of each extra dollar of income that households spend rather than save. A higher MPC means more is re-spent at every round, so the ripple runs longer and the multiplier is bigger. The tax multiplier is smaller than the spending multiplier, because when taxes are cut, households save part of the windfall instead of spending the whole amount.