Understanding "Multiplier"

In our very first article of this blog, we mentioned about the misconception of economics, the fact that 99.5% of the entire population thinks of an economy solely in term of money. Where did I get the data? I made it up. That is what economists do daily. Make things up. Actually, that is another one of the widespread misguided belief. It is true that 99.5% is just a made-up number, but you should be able to grasp what I meant. The vast majority (a vague but somehow a justifiable and easy-to-use cliché, “vast majority”) of people still think of economics as a not-so-scientific-bedtime story about money. WRONG, I said (and a bunch other economists said)!

So before we begin, let us clear our mind of all the preconceived notions we once held about economics. Economics is not about money, but it is more about converting scarce resources, which have alternative uses, to outputs. Actually, I would prefer it if you associate economics with outputs. Though it is not the perfect proxy, it is still much more suitable, especially in the context of today’s discussion about Multiplier.

I have already mentioned about the virtue and vice of spending, but now, let us focus on the good side. If this is the first time you hear “Multiplier”, you are probably thinking about multiplication, and you are right. Multiplier multiplies. It does not get any simpler than this. Multiplier multiplies spending.

Wait, what? Multiplies spending?
Yes, you read it right. You do not need your glasses yet. In economics, a $100 spent by Mr.A is not a $100 received by the economy. This is not business 101. Forget about business and accounting, this is Economics 101.

In an economy, spending $100 will get you either more or less, but almost always, especially in a robust economy, you get more. This very idea justifies and advocates government spending (the use of stimulus packages, etc), and most of the time, encourages the government to run deficits (i.e. spend even if it exceeds their earning, meaning borrow to spend) in accordance with Keynesian economics in which multiplier is most used and accredited.

The idea is that spending money or injecting money into circulation within an economy will generate even more money, or to be more specific (and correct), value of outputs. As long as the first recipient of the $100 (from whoever spent it) continues the tradition by spending a portion, no matter how small, of that $100, the economy will receive more than the initial amount ($100) spent. I guess a few, or let be optimistic, some of you, by this point, have already understood the underlying concept that I am trying to explain. To illustrate it further, here is an example:

“Iron man paid $5 to Batman’s butler to wash and iron his iron suit (I do not know how that can be done either). Batman’s butler, in turn, saved $1 and spent the rest ($4) to buy Batman’s favourite pizza from the fast-delivery spidy pizza owned by Spiderman. Spiderman kept $1 (of the $4 he received) in his bank account, and spent the rest ($3) on getting a new and cooler mask. Let us assume that the mask maker (whoever that is, probably the Hulk) saved all the $3 proceeds and stopped the spending chain here.”

Now let us re-think of what we get so far from the perspective of the whole economy. What do we have up till now in term of the goods and services produced?

  • Batman’s butler received the $5 which is the value of his washing and ironing service for Ironman. So we have 1 washing and ironing service produced at $5.
  • Spiderman received $4 to make a mouthwatering finger linkin’ pizza for batman. So here a pizza was produced in this particular economy at the price of $4.
  • The mysterious mask maker (whom I thought might be the Hulk) got paid $3, and he produced a cool-looking mask for spiderman. He just decided to keep it for whatever the reason. So we have a mask produced at the price of $3.

To sum up, the economy has gained:

= a $5 washing and ironing service + a $4 mouthwatering pizza + a $3 mask

= 3 goods and services in total with the value of $12

From this simple example, we have thus proved the point that money spent will generate more than the initial amount for the economy. This is not about money creating money, but this is about money creating outputs which are valued in term of money.

I can safely say (based on the example I made up) that multiplier does exist. If you ever wonder what the value of the multiplier is in our example, just do the maths.

Multiplier = $12 (total outputs)/$5 (initial capital injection or money spent) = 2.4

Now what if the initial spending is $1 million instead of $5?

Using the multiplier, then the total increase in the overall production of goods and services in the economy would be $1million x 2.4 = $2.4 million!

Multiplier is extremely important as it determines the effectiveness of spending in an economy. In a consumerism society, where people save less and spend more, we would expect the multiplier effect to be much stronger than that of the one favouring saving. That is why the same amount of government spending does not yield the same result when applied in different countries across the globe. This is why economic research is crucial in understanding both the short-term and long-term consequences of a policy, for instance, expansionary fiscal policy which is pretty much about government increasing spending.

And that wraps it up for today. Just one last reminder though.

Remember folks, MULTIPLIER is NOT magic.