Definition
The multiplier effect describes how an initial injection of spending into an economy leads to a final change in total output that is larger than the injection itself. When the government, a firm, or a foreign buyer spends an extra amount, that amount becomes income for someone else, who then spends part of it again.
Each successive round of spending is smaller than the last, because some income leaks out into saving, taxes, and imports. The full series of rounds, summed together, gives the total impact, which exceeds the original change.
Why it matters
How it works
Suppose the marginal propensity to consume is 0.8. An extra 100 units of spending creates 100 of income; recipients spend 80, which becomes income for others, who spend 64, and so on. The geometric series sums to a total of 500, so the simple multiplier is five.
In general the multiplier equals one divided by one minus the marginal propensity to consume. The more income leaks into saving, taxes, and imports each round, the smaller the multiplier becomes.