The multiplier effect is the term used to describe the impact that changes in monetary supply can have on economic activity. When an individual, government or company spends money it has a trickle-down effect to businesses and individuals. The resulting impact can be much wider than the initial action.
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The multiplier effect can arise in many different forms, such as government spending, exports income, consumer spending and so on. Two common examples of the multiplier effect are:
When a customer deposits cash into a bank, the bank has to keep a certain portion of it (the reserve requirement) but is free to loan the rest out to other customers. Those customers can spend the cash, and it will eventually end up being deposited in another bank.
Part of the new deposit will be reserved by the new bank – once again, because of the reserve requirement – and part of it will be loaned again. This process will carry on until eventually all of the initial deposit is deposited in banks. By this process, the initial deposit has been multiplied and used several times.
If a company has particular success with investment into a new product line, the multiplier effect can be seen through the increase in business of other companies that contribute to the new product (by producing raw materials or transport, for example).
The company’s employees may also receive an increase in salary, which would lead to increased consumer spending. The impact on GDP is thus increased beyond the initial success of the product line.
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