27 Apr Spending Multiplier
What is the Spending Multiplier?
Definition: 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).
What does Spending Multiplier mean?
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.
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.
The money that the government spends will be used by the people who receive it, to buy various goods and services. The people who supply these goods and services will, in turn, spend the amounts that they receive.
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.
Using this information, we can calculate the spending multiplier:
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.)
Example of the Spending Multiplier
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.
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.
When the US entered World War II in 1941, there was a sharp rise in industrial production. The New Deal and the increased economic activity due to WW II finally ended the American recession.
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.