27 Apr What is the Spending Multiplier?
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The spending multiplier refers to the effect that increased government spending will have on a country’s economy. The term is used to indicate the fact that a small increase in government spending can result in a relatively large rise in a country’s gross domestic product (GDP).
When the government incurs any expenditure, it puts money into the hands of the country’s citizens. Consider a situation where the government decides to spend $100 million on building a new road.
What does spending multiplier mean?
This money will be used for:
- Buying road construction equipment, engineering equipment, and heavy vehicles.
- Paying wages to workers.
- Incurring other expenditure associated with the project.
In this manner, the total expenditure in the country’s economy will be much greater than the government expenditure of $100 million on building a road. That’s because each person who receives money will spend a part of it.
How much greater will the expenditure be? That’s exactly what the spending multiplier tells you.
When a person receives money, a part of it is spent and the remaining is saved. Say, a person spends 75% of every dollar that is received. In this situation:
- The marginal propensity to consume (MPC) is 0.75 and
- The marginal propensity to save (MPS) is 0.25.
Spending multiplier = 1 / (1 – MPC)
Spending multiplier = 1 / (1 – 0.75)
Spending multiplier = 1 / 0.25
Spending multiplier = 4
So, if people spend 75% of every dollar that they earn, the spending multiplier is 4. The government’s road project, which involves an expenditure of $100 million will result in an increase in GDP of $400 million ($100 million X 4.)
The year 1929 saw the US economy entering into a recession. Unemployment soared, the economy contracted, and 10,000 of the country’s banks failed.
Example of the spending multiplier
What did the government do to overcome this situation? It introduced the “New Deal,” a program launched by the Roosevelt administration. The New Deal was a series of government initiatives that attempted to boost demand and get the country’s economy back on track.
Some of the measures that were introduced were:
- Building a series of dams along the Tennessee River. This created employment and helped to generate power for the people in the region.
- Commodity farmers were paid to leave their fields fallow, resulting in an end to agricultural surpluses and low prices.
- A number of new construction projects were launched. The government paid for building new post offices, bridges, schools, highways, and parks.
In 1933, US GDP stood at $778 billion in real terms. By 1944, it had almost trebled to $2.2 trillion. A large part of this increase was because of government spending and the multiplier effect.
When the government makes an expenditure, the increase in a country’s GDP is much larger than the amount spent because of the effect of the spending multiplier.