multiplier effect

Drop a stone in a pond and the ripples spread far beyond the splash. Spending in an economy works the same way. When someone spends an extra dollar, that dollar becomes income for someone else — who then spends part of it, becoming income for a third person, and so on. The first dollar of spending keeps echoing through the economy, so the final boost to total income ends up larger than the original spending. That amplification is the multiplier effect.

Here is the arithmetic in words. Suppose people spend 80 cents of every extra dollar of income they receive (that fraction is called the marginal propensity to consume). A new $100 of spending becomes $100 of income; the recipients spend $80, which becomes income for others; they spend $64; then $51, and so on, in a shrinking chain. Adding up the whole infinite series gives a total of $500 — five times the original. The multiplier here is 5, calculated as 1 divided by (1 minus 0.8). The more of each dollar people re-spend rather than save, the bigger the multiplier; the more that leaks out into saving, taxes, or imports, the smaller it is.

The multiplier is why economists argue that a dollar of well-targeted government spending in a slump can raise total output by more than a dollar — and equally why a collapse in private spending can snowball into a much larger downturn. It is the engine behind both the Keynesian cross and the paradox of thrift. The honest caveats are large, though: real-world multipliers are hotly debated and depend heavily on circumstances — they are bigger when there is idle capacity and interest rates can't rise to offset the spending, and much smaller when the economy is already near full capacity or the extra spending crowds out private activity.