EFA (3): The multiplier

We at Business Spotlight love multipliers. These are people such as teachers and trainers who tell lots of other people about our products.

In economics, "multiplier" has a different meaning, which is the subject of the third item in our Economics for Amateurs (EFA) series. You can find this series here every Monday.

The idea behind the multiplier is very simple. If the government spends extra money — for example, on new computers for schools — the people who receive that money, the retailers, will spend all or part of it.

The people who receive money from the retailers — the workers, the manufacturers of computers, etc. — will also spend part or all of this money, for example on food or entertainment. And so on.

In this way, the original spending cascades through the economy, creating new rounds of spending and therefore production. The multiplier tells us the ratio between the final increase in output and the original increase in spending.

The more people spend of any extra income they receive, the higher the multiplier is. The amount people spend out of each extra dollar is called their "marginal propensity to consume" (MPC).

So, if people spend 50 cent of every extra dollar, their MPC is 0.5. For those of you who like (or can bear) a little maths, the multiplier can be calculated by this formula:

• Multiplier = 1 / (1-MPC)

With an MPC of 0.5, this gives a multiplier of 2 (1 divided by 0.5). A $100 million increase in spending would lead to a rise in output of $200 million.

Of course, there are other ways money can leak out of the economy, for example by being spent on imports. The multiplier is also lower if government spending is financed by higher taxes.

This may all sound very theoretical, but arguments between economists about the size of the multiplier have become central to discussions about the effect of economic stimulus packages.

For example, Barack Obama's economic advisors believe that the multiplier around 1.5, and that his stimulus package will create more than 3 million jobs.

Opponents say the multiplier is actually much lower than one — meaning that an increase in government spending creates less extra output than the initial spending. In this case, the increase in jobs from Obama's package would be just 600,000.

That shows why the size of the multiplier is so important in practice.