Decoder: The 'multiplier effect'
The Obama administration says the economic stimulus plan's price tag will be worth the cost -- and then some -- because of something called the "multiplier effect." What does that mean? Sally Herships explains.
Employee adds to growth on bar chart. (iStockPhoto)
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TEXT OF STORY
Tess Vigeland: Congress will keep wrangling over the economic stimulus plan this week. President Barack Obama upped the pressure on lawmakers. He said the bill isn't perfect, but that the failure to act would turn the economic crisis into a catatrosphe.
He's been trying to sell the idea that all this massive government spending is worth it. In part, because of something called a multiplier effect. You'll be hearing this term a lot: Multiplier. But, what does it mean?
Reporter Sally Herships has the answer in today's Marketplace Decoder.
Sally Herships: The multiplier effect is all about spending and generating a return for the economy. Justin Wolfers is a professor of business and public policy at Wharton. He says, say the government builds a bridge:
Justin Wolfers: The money it spends turns out to be income for someone else say a construction worker, that construction worker with his or her greater income will maybe go and buy more groceries.
The grocery store owner now has more income.
Wolfers: Maybe he'll need to hire extra cashiers.
And maybe they'll all need to go and buy new clothes.
Wolfers: And so on.
So the multiplier is simply the way the government's spending ripples through the economy. Say you drop a stone in a pool. The first wave is like the money the government pays our construction worker. The subsequent ripples are weaker but they spread across a wide area. Justin Wolfers says Obama's economic experts are estimating the multiplier, or the sum of those subsequent ripples, will be 1.6 times the initial amount.
Wolfers: So government spending has a multiplied effect on gross domestic product. The overall effect is going to be bigger then the initial effect.
The administration's talking about spending almost a trillion dollars. It's hoping that'll generate $1.6 trillion throughout the economy. But Wolfers says no one's sure that'll happen.
Wolfers: We're tremendously uncertain about it. We economists are always both absolutely friendly and always at war. What is the multiplier? Is it zero? Is it five? Or does it lie somewhere in between and as a result how big should this stimulus package be?
You've got to get the initial spending number right Wolfers says. If it's too small, the economy may not budge. But if the number's too large, and the government doesn't have the cash on hand, well back to our imaginary bridge for a moment.
Wolfers: In order to fund that bridge the government's going to have to borrow money. If the government's borrowing money it may be that there's less money available for the private sector to borrow.
And taking money out of the mouths of the private sector will crimp growth, which isn't multiplying anything.
I'm Sally Herships for Marketplace Money.
Comments
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From Honolulu, HI, 05/30/2009
The multiplier is supposed to have a 'rippled' effect on the economy, i.e. through government funding, the level of consumption will be raised. This in turn leads to a rise in aggregate demand, and since the economy is/was in a recessionary period, the rise in demand will cause economic growth to occur (without the risk of 'overheating'). And according to John Maynard Keynes, if aggregate demand is raised during a recessionary period, then employment will be encouraged, as people consume more, demand more, and hence, supply by firms would need to be increased.
The multiplier, however, also depends on an individual's Marginal Propensity to Consume. Some people may spend more than others, which is why the value of the multiplier of 1.6 may not be accurate.
So, to again influence consumption levels to rise, The Federal Reserve Bank could consider cutting interest rates (Monetary Policy).
All in all, the multiplier will bring about a stimulus in the economy.
From HI, 04/01/2009
"
multiplier effect
"
Yes but what about the *divider effect*? It is monkey see; monkey do. Foreign politicians see USA politicians using the divider effect then do same thing.
What happens when a foreign government looks at how fat all the poor people are, looks at how the poor have too many children who have too many children who pollute the atmosphere and taint the waters exponentially until nobody can drink, nobody can breath. As this scenario appears to them they do as monkey does, they use divider effect. They tax the fire out of poor then give billions to bank presidents.
Look out of your window! How many new saw-mills and new factories do you see? How many new banks do you see? Big new banks with architecture straight from Disney World -- beautiful marble
Got it?
From Lutcher, LA, 03/23/2009
The current stimulous packages strikes me as "PRIMING THE PUMP." Since money is a concept that we humans have devised, I am amazed and perplexed at how we use it and are moved by it in so many ways.... Just an observation!
From Winston-Salem, NC, 03/09/2009
From David Dyer below: "There is no empirical data to prove a multiplier effect exists. It is fallacious Keynesian economic theory with no demonstrabel basis in fact."
Incorrect. There is substantial evidence of the multiplier. The fallacy is assuming all multipliers are equal: govt. spending will always produce lower multiples than comparable private sector spending. And the comment below about "spent locally" is the central point of why a(ny) multiplier works; this is essential.
From Orlando, FL, 02/25/2009
There is no empirical data to prove a multiplier effect exists. It is fallacious Keynesian economic theory with no demonstrabel basis in fact.
If the government builds a bridge it must either acquire the money through taxes or borrowing. If it uses tax dollars, that ripple effect Wolfers mentioned is negated by the purchases of goods and services NOT made by the people from whom the money was taken. If the government borrows the money, the ripple effect is negated by a company or consumer in the private sector NOT having that money available to produce goods and services or purchase them, not to mention the fact that the increased demand for funds by government puts upward pressure on interest rates, mking all investment more expensive.
Those who believe the multiplier exists (especially Obama and his advisors) would do well to read Henry Hazlitt's Economics in One Lesson.
From Portland, OR, 02/22/2009
Keep in mind that for a multiplier effect to stimulate your local economy the money needs to be spent locally. The more that same dollar is spent on clothes for the sales clerks or nails for the carpenters in locally owned and operated businesses the stronger it remains.
One of the issues I believe is that we've created a sort of sieve that filters a lot of money out of our communities and into corporate centers that then pay mostly minimum wage back home.
A bit of a catch 22 these days when we want as much as possible for as little as possible, and thus continues the cycle. Reminiscent of the company towns a bit...
From Fargo, ND, 02/19/2009
The world is becoming an increasingly complex or interrelated place where bad economic fundamentals in one nation can and do effect all other nations.
I believe for the Multiplier effect to have maximum lasting effect the large doses of cash input to the U.S. system must be staged to take into account and therefore take advantage of changes in people's overall attitude about the world economy.
Such infusions of billions of dollars of cash must be timed to fight against a tendency for people to fall-back into a depressed state of mind or anxiety about the economy.
Thus, causing the economy to "drag its feet", but rather instead by timing several massive influxes of cash it is hoped overall attitudes would be positively affected over a longer timespan.
From Atlanta, GA, 02/15/2009
We have to start somewhere,at some point we have to make a decision. Of course, President Obama is searching for plans that will promote growth in the economy that will put americans in a better position than the one we are currently in.It may seem like going backwards but its definately not,The multiplier makes alot of sense coming from President Obama. It sounds like a good idea to me and I bet many agree.
From Winston-Salem, NC, 02/09/2009
A multiplier of only 1.6? That's embarrassing! If we're going into debt to create "stimulus" (a bad idea by the way), it should be spent on things where the multiplier is at least 2.5.
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