What is the "multiplier effect"?

The multiplier effect (the spending multiplier to be specific) basically says if the government spends some amount of cash, the equilibrium level of GDP will increase by more than that amount of cash. The multiplier itself is just the ratio of the increase (i.e. - if the multiplier is 2, if the government spends 100 billion, the equilibrium level of GDP should increase by 200 billion).

Why should this be true though? It is based on the marginal propensity to consume and the marginal propensity to save (MPC and MPS). Those fancy words just mean what percent of each dollar does the economy save and consumer.

Let's assume MPC = 0.9 and MPS = 0.1 which says we consume 90 cents of each dollar made and save 10 cents of that same dollar. If the government purchases 100 billion dollars of "stuff," GDP will increase by 100 B... but those producers will have generated 100 B... so they save 10% and spend 90% of it, which is 90B. So now GDP increases by 90B up to a total increase of 190B.

But, whatever they spend that money on, those producers have just received 90B in income... they save 10% and spend 90%, which is 81B. So GDP increases another 81 billion. And the processes goes on and on and on until we are dealing with pennies.

The multiplier is a shortcut to the end result, but the above is the why (technically, the multiplier equation is just the summation of an infinite series).

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