Multiplier effect

The multiplier effect is the effect of an injection of income into an economy upon the total income of that economy, which is a definitional consequence of the circular flow of income model of the economy. The effect is to raise the total income of the economy by a multiple of the initial injection. and its magnitude is limited by income "leakages" (into, for example, taxation or spending on imports). If the recipients of the increases in income would otherwise be unemployed, the effect takes the form of an increase in the level of activity in the economy: if they would otherwise be fully employed, it takes the form of an increase in the general level of prices.

Simple multiplier models embody the implicit assumption that income leakages are a fixed proportion of the initial injection, and that the multiplier is consequently invariable. They assume, for example, that a community's marginal propensity to save is a behavioural constant. More sophisticated models take account of the effect upon behaviour of the perceived permanence or otherwise of the income injection. Robert Barro has argued that the multiplier effect of an increase in public spending is zero because taxpayers save an equivalent amount in anticipation of a subsequent tax increase. The multiplier effect may also be influenced by changes that are associated with the initial injection. It has argued that interest rate increases caused by government spending cause an offsetting "crowding out" of private sector investment .

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