In economics, a multiplier broadly refers to an economic factor that, when increased or changed, causes increases or changes in many other related economic variables. In terms of gross domestic product (GDP), the multiplier effect leads to gains in total output that surpass the initial shift in spending that caused it.
The term multiplier is often used to describe the relationship between government spending and total national income. Additionally, multipliers are used in explaining systems such as fractional reserve banking, known as the deposit multiplier.
Key Takeaways
- A multiplier amplifies the effect of some other outcomes.
- A multiplier value of 2x would double an effect; 3x would triple it.
- Examples include margin in trading or the money multiplier in fractional reserve banking.
Understanding Multipliers
A multiplier is simply a factor that increases or amplifies the base value of another variable. For instance, a multiplier of 2x would double the base value, whereas a multiplier of 0.5x would reduce it by half.
The Fiscal Multiplier
The fiscal multiplier is the ratio of additional national income created to the initial increase in spending or tax reduction that led to that income. For example, if consumers have a marginal propensity to consume (MPC) of 0.75, a $1 billion fiscal stimulus results in consumers spending $750 million, creating subsequent rounds of spending and further increasing overall income.
The Investment Multiplier
Similarly, an investment multiplier quantifies the more-than-proportionate positive impact of public or private investment on aggregate income and the general economy. Investment multipliers indicate how efficiently investments create and distribute wealth throughout an economy.
The Earnings Multiplier
An earnings multiplier relates a company’s stock price to its earnings per share (EPS). It is computed as the stock’s market price divided by its EPS and is commonly referred to as the earnings multiple.
The Equity Multiplier
The equity multiplier is a commonly used financial ratio, calculated by dividing a company’s total asset value by its total net equity. It measures financial leverage, where a higher multiplier suggests a larger portion of asset financing comes from debt.
The Keynesian Multiplier Theory
British economist John Maynard Keynes theorized that government spending aims to proportionally increase overall income for the population. In his 1936 book, “The General Theory of Employment, Interest, and Money,” he introduced this relationship:
1Y = C + I
2
3where:
4Y = Income
5C = Consumption
6I = Investment
For any given level of income, people spend a fraction and save or invest the rest. The theory uses marginal propensity to save and consume to determine income distribution and shows that investments are repeated by other members of society, enriching many.
The Fractional Reserve Money Multiplier
If a saver deposits $100,000 in a savings account and the bank loans out $75,000 to a company with a 25% required reserve ratio, that deposit can ultimately create additional demand deposits of up to 4 times the initial amount due to repeated lending and spending rounds.
This initial deposit cycles through various actors like electricians and plumbers who use the funds per their needs, generating income for each party involved. The money multiplier demonstrates how investment effectively multiplies income across numerous channels within the economy.
It’s essential to note that the deposit multiplier is often confused with the money multiplier, yet the money multiplier, which reflects actual changes in the nation’s money supply due to loan capital, is always less than the deposit multiplier that indicates potential money creation.
Related Terms: marginal propensity to consume, marginal propensity to save, gross domestic product, money supply, financial leverage.
