Explaining the Multiplier Effect

An initial change in aggregate demand can have a greater final impact on the level of equilibrium national income.

This is known as the multiplier effect - the multiplier is explained in our short revision video below.

The multiplier effect is one of the most important concepts you can use when applying, analysing and evaluating the effects of changes in government spending and taxation. It is also good to use when analysing changes in exports and investment on wider macroeconomic objectives.

The multiplier effect occurs when an initial injection into the circular flow causes a bigger final increase in real national income. This injection of demand might come for example from a rise in exports, investment or government spending.

The multiplier coefficient itself is found by:

Final change in real GDP / Initial change in AD

Example: If the government increased spending by £5 billion but this caused real GDP to increase by a total of £12 billion, then the multiplier would have a value of 12/5 = 2.4

The multiplier effect arises because one agent’s spending is another agent’s income. When a spending project creates new jobs for example, this creates extra injections of income and demand into a country’s circular flow.

The negative multiplier effect occurs when an initial withdrawal or leakage of spending from the circular flow leads to knock-on effects and a bigger final drop in real GDP.

Quizlet revision resource on the multiplier and the accelerator effects