Spending multiplier

economic-dictionary

The spending multiplier refers to the increased effect that increased public spending has on the economy. That is, the increase greater than one for each invested currency.

By multiplying effect of public spending it is understood that the impulse or initial expenditure made by the government will be increased by a series of chain effects. In this way, the increase in public spending in X will result in an income growth of the economy greater than X.

How the multiplier effect of spending occurs

Suppose the government spends 1 million euros to hire carpenters to remodel some government buildings. The carpenters will receive this money as wages. Part of those wages will be spent on other goods and services (let's say new shoes). Producers of shoes will have additional income, part of which they will also spend on other workers and goods. The benefited producers and workers will continue with the process and will also spend part of their salary. At the end of this recurring process, the increase in national income will be greater than 1 million euros.

If, with an expense of 1 million euros, the final product increases by 3 million euros (due to secondary expense), the multiplier effect is 3.

In theory, the multiplier effect of spending is greater in less developed economies than in those with a higher degree of development. This is due to the fact that people may have a greater propensity to consume and that, if investment spending (roads, schools, etc.), its impact is greater (since capital is scarcer).

Origin of the multiplier effect

Neoclassical Economics defended the idea that the market would lead us to an efficient equilibrium and that the imbalances in the economy would be resolved, leading to full employment.

The Great Depression of the 1930s, where unemployment existed for a long period of time, gave rise to economic theories that promoted the intervention of the State as a regulating agent of the economy. Within these theories, the multiplier model emerged, which called for increasing public spending to increase production and employment.

The multiplier model was invented by Richard Kahn, Keynes's friend and collaborator, who made him universally famous.

Spending multiplier formula

The multiplier effect of spending depends fundamentally on the propensity to spend of individuals and companies, which gives rise to a chain of secondary expenses.

The formula is as follows:

1 / (1-PMC)

Where:

PMC: Marginal Propensity to Consume. It is the proportion of income that consumers spend on other goods and services (taking everything else constant).

Criticisms of the public spending multiplier

There are several criticisms of the public spending multiplier model. Here are the most relevant ones:

  1. The model is very simple and short-term, it does not control for effects on imports, price changes, etc.
  2. It is not considered that government spending should be financed with taxes, which reduces disposable income and therefore the multiplier effect.
  3. Government spending can displace part of private investment or spending.

Tags:  Business famous-phrases accounting 

Interesting Articles

add