The Expenditure Multiplier Effect

Keynesian economics has another important finding. You’ve learned that Keynesians believe that the level of economic activity is driven, in the short term, by changes in aggregate expenditure (or aggregate demand). Suppose that the macro equilibrium in an economy occurs at the potential GDP, so the economy is operating at full employment. Keynes pointed out that even though the economy starts at potential GDP, because aggregate demand tends to bounce around, it is unlikely that the economy will stay at potential. In 2007, U.S. investment expenditure collapsed with the fall of the housing market. As a result, the U.S. economy went into the Great Recession. But how much did GDP fall? Suppose investment fell by $100 billion. You might expect the result would be that GDP would fall by $100 billion too. If so, you would be wrong. It turns out that changes in any category of expenditure (Consumption + Investment + Government Expenditures + Exports-Imports) have a more than proportional impact on GDP. Or to say it differently, the change in GDP is a multiple of (say 3 times) the change in expenditure. This is the idea behind the multiplier.

The reason is that a change in aggregate expenditures circles through the economy: households buy from firms, firms pay workers and suppliers, workers and suppliers buy goods from other firms, those firms pay their workers and suppliers, and so on. In this way, the original change in aggregate expenditures is actually spent more than once. This is called the expenditure multiplier effect: an initial increase in spending, cycles repeatedly through the economy and has a larger impact than the initial dollar amount spent.

How Does the Expenditure Multiplier Work? 

It’s easiest to see how the multiplier works with an increase in expenditure. Suppose government spontaneously purchase $100 billion worth of goods and services, perhaps because they feel optimistic about the future. The producers of those goods and services see an increase in income by that amount. They use that income to pay their bills, paying wages and salaries to their workers, rent to their landlords, payments for the raw materials they use. Any income left over is profit, which becomes income to their stockholders. Each of these economic agents takes their new income and spend some of it. Those purchases then become new income to the sellers, who then turn around and spend a portion of it. That spending becomes someone else’s income. The process continues, though because economic agents spend only part of their income, the numbers get smaller in each round. When the dust settles the amount of new income generated is multiple times the initial increase in spending–hence, the name the spending multiplier. The table below gives an example of how this could work with an increase in government spending. Note that the multiplier works the same way in reverse with a decrease in spending.

Table 1 works through the process of the multiplier.  Over the first four rounds of aggregate expenditures, the impact of the original increase in government spending of $100 creates a rise in aggregate expenditures of $100 + $90 + $81 + $72.90 = $343.90, which is larger than the initial increase in spending. And the process isn’t finished yet.

The multiplier applies to any type of expenditure (e.g. C + I + G + X-M), and it applies when expenditure decreases as well as when it increases. Say that business confidence declines and investment falls off, or that the economy of a leading trading partner slows down so that export sales decline. These changes will reduce aggregate expenditures, and then will have an even larger effect on real GDP because of the multiplier effect.