Multiplier effect

In economics, the ripple effect caused by the re-spending of income. Money spent in a local economy is re-spent by employees and suppliers, so the multiplier tries to calculate how many times this occurs.

How does this work? Imagine a tourist spends $100 on a hotel room. The hotel owner divides up that money to pay employees and suppliers (say, $60 goes to employees and another $10 to local suppliers). The employees and suppliers go out and spend money (buying groceries, for example) and of that $70, let's say $30 stays in the local economy to shopkeepers, suppliers, etc (induced effect). So the original spending might be calculated to have a multiplier effect of 2 ($100 (direct impact)+ $70 (indirect impact)+ $30 (induced effect)/$100 (direct impact) = 2); meaning that $200 was circulated through the local economy.

Urban and regional planners use the multiplier effect to calculate the net impact of a given or proposed economic activity (One reason that local governments may choose to subsidize developments such as sports stadiums or shopping destinations or arts districts is the expectation that these projects will bring in money to the local economy).

The other method of local economic development that relies on the multiplier effect is "plugging the leaks," a strategy that encourages consumers to "buy local," thereby keeping money circulating locally. (Locally owned small businesses increase the multiplier effect, while corporate owned chains have a smaller effect as profits are exported out of a local economy to the corporate owner elsewhere).

Sources:
Vivian C. Choi, "On the Multiplier Effect," Guam Department of Commerce, March 2001, <http://www.admin.gov.gu/commerce/multiplier.htm> (25 March 2002)
Cathy Cockrell, "Professional sports haven't delivered promised benefits ...," UC Berkeley Press Release, 20 August 1998, <http://www.berkeley.edu/news/media/releases/98legacy/08-20-1998.html> (9 April 2002)
Marie Easley, "Measuring Economic Impact," Partners, Spring 1998, Federal Reserve Bank of Atlanta, <http://www.frbatlanta.org/invoke.cfm?objectid=DC6ADC32-8061-11D5-897D00609459DBE6&method=display> (8 April 2002)
Amos Ilan, Richard W. Roper, et. al., "Total Impacts," Council for Higher Education in Newark Economic Impact Report 2000, <http://www.chen-nj.org/total_impacts.htm> (9 April 2002)

The multiplier effect, the cornerstone of Keynesian fiscal policy, states that an increase in autonomous spending (on consumption expenditures, gross private domestic investment, government spending, or net foreign investment) will cause a multiple growth of aggregate demand. Keynesian economists believe that this increase in aggregate demand will cause an equal increase in gross national product, whereas classical economists believe that this increase will only lead to an increase in the price level (inflation).

The multiplier is dependent on the marginal propensity to consume. It is best explained by example. Assuming the marginal propensity to consume (MPC) is 0.8; the marginal propensity to save (MPS) will be 0.2 because MPC+MPS=1. If Bob finds $100 buried in the ground and spends it at the local computer store, the gross national product will have increased by $100 through the new spending. The owner of the computer store will decide to save $20 (0.2*$100) and spend $80 (0.8*$100). The owner spends the $80 at a tailor for a suit. The increase in disposable income by finding $100 has yielded an increase in $180 in gross national product. He will save $16 (0.2*$80) and spend $64 (0.8*$80). Expanding this a few more rounds:

1: $100  ,-> $80  ,-> $64  ,-> $51.2  ,-> $40.96
2: x .8  |   x.8  |   x.8  |   x  .8  |   x   .8
   ----  |   ---  |   ---  |   -----  |   ------
3:  $80 -'   $64 -' $51.2 -'  $40.96 -'  $32.768

1: The input money
2: The MPC
3: The ouput money

This continues ad infinitum. If you add the original $100 to all the outputs, you will get $500:

$100
  80
  64
  51.2
  40.96
  32.768
  26.2144
  20.97152
  16.777216
  13.4217728
  10.73741824
+ 42.94967296 == all other rounds
-------------
$500

This $500 is also equal to $100 * (1/0.2) because 0.2 is the MPS and some mathematical stuff I won't explain here. It has to do with the fact that it is the sum of the infinite series $100 * 0.8^x, where x is the set of integers from 0 to positive infinity.