Definition: The spending multiplier, or fiscal multiplier, is an economic measure of the effect that a change in government spending and investment has on the Gross Domestic Product of a country. In other words, it measures how GDP increases or decreases when the government increases or decreases spending in the economy.
What Does Spending Multiplier Mean?
This concept is inversely related to the marginal propensity to save. Thus, if consumers are saving more of their marginal dollars, the multiplier will be diminished greatly.
That is why economists in the Federal Reserve and governmental organizations use this to determine the amount of stimulus that is appropriate for the economy. If MPS is higher, consumers save more and the multiplier decreases creating a smaller and less effective stimulus. If consumers spend more and save less, the multiplier will increase and create a greater stimulus effect.
In this way, the spending multiplier is closely tied with the economic concept of the multiplier effect. One small change in the government’s activities will create a big change in the overall economy.
The spending multiplier formula is calculated by dividing 1 by the MPS. It can also be calculated by dividing 1 by 1 minus MPC.
Let’s look at an example.
Matthew is an economist in the Federal Reserve, and he has been tasked with figuring out the ideal stimulus would be in order to increase GDP by $5,000,000. He reasons that in order to do that, he needs to figure out how much of their income consumers spend, and how much they save. Through looking at the market and statistical data, he sees that consumers are saving 35% of their after-tax income, while spending 65% of it.
Using the spending multiplier formula (1 / MPS), he calculates that the Federal Reserve needs to inject (5,000,000 / 2.86) = $1,748,251.75 into the economy based on the current MPS.
Why does the government only have to spend $1.7M to increase GDP $5M? This is because of the multiplier effect. One group of consumers consumes 65% of its new money on goods produced by another consumers. This consumer now has new money and consumes 65% of it on goods produced by someone else and so on.
Thus, consumers immediately consume 65 percent of this increase ($1.7M x .65). This $1.1M of consumption then triggers another line of consumption where these consumers consumer 65% of their earnings ( .65 x .65 x $1.7M).This goes on and on resulting in a multiple of 2.86.
The Spending Multiplier is largely related to how much consumers save, so if they save only 20% of their income and spend the rest, then whatever stimulus the Fed provides is magnified by 5 (1 / (0.2) = 5). This is the reason governments encourage spending during recessions. It can stimulate the economy and increase the flow of money.