In a simple economy, households and firms interact in two markets: the goods & services market and the factors market. The flow of money and goods creates a loop that keeps the economy running.
Households supply labor to firms and receive wages. They use those wages to buy goods and services from firms, completing the cycle.
When the government or a firm injects new spending into the economy, the initial increase in income leads to further rounds of spending. This chain reaction is captured by the multiplier.
The multiplier is the ratio of the change in national income to the initial change in autonomous spending.
| Symbol | Meaning |
|---|---|
| ΔA | Initial change in autonomous spending (e.g., government spending, investment). |
| ΔY | Resulting change in national income. |
| k | Multiplier. |
The MPC is the fraction of an extra dollar that households spend rather than save. The multiplier can also be expressed as:
\$k = \dfrac{1}{1 - \text{MPC}}\$
If households spend 80 % of any extra income (MPC = 0.8), then:
\$k = \dfrac{1}{1 - 0.8} = \dfrac{1}{0.2} = 5\$
So, a £1 million increase in investment would ultimately raise national income by £5 million.
Drop a stone into a calm pond. The first splash is the initial spending. Each subsequent ripple spreads further, representing the additional rounds of spending. The total area covered by the ripples is like the total increase in income.
Ready to calculate your own multiplier? Try plugging in different MPC values and see how the total effect changes! 🚀