Multiplier effect

The multiplier effect is the effect of an injection of income into an economy upon the total income of that economy. It 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. The magnitude of the effect is limited by "leakages" from the injected income 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 . The multiplier effect may also be influenced by the state of the economy at the time of the injection. Following the bursting of an house price bubble, for example, households may use additional income to repay debt instead of spending it.

Estimates of the magnitude of the multiplier effect of fiscal changes have been made by regression analysis of past data, and also by fitting past data into economic models . Such methods have typically yielded multiplier values between 0.5 and 1.5.