Multiplier effect definition

The multiplier effect is an economic term for when changes in money supply are amplified from the knock-on effects of economic activity.

When an individual, government or company does something that has an impact on the economy, the trickle-down to other people and business can make the impact much wider than the initial action.

Example one

The multiplier effect can arise in many different forms, but bank lending is a common example. 

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 deposited and used multiplied several times.

Example two

In another example, if a company has particular success with a new product line, the multiplier effect can be seen in the increase in business for other companies that contribute to the new product line (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.