The Multiplier Effect

Y= C + S where Y=Income, C = Consumption, S= Saving

AE = Y = C + I + G + (X-M)

C= function(Y), therefore, C= a + by

Lets take some figures to get a better understanding of this effect.

Assume that C= 10 + 0.8Y, I= 10, G= 10, (X-M)= 5

Y = C + I + G + (X-M); lets plot it in.
Y = 10 + 0.8Y + 10 + 10 + 5
Y = 0.8Y + 35
Y = 175

Imagine that Goverment wants to build more schools, G increases by 2.5;
Again take Y = C + I + G + (X-M);
This time round, G instead of 10, now become 12.5;

Lets see what happened.

Y = 10 + 0.8Y + 10 + 12.5 + 5
Y = 0.8Y + 37.5
Y = 187.5

Calculating the growth rate, (187.5-175)/175 X 100% = 7%


In layman's terms, when the Goverment wants to build more schools, they will outsource the jobs to different companies. Similarly, companies will need to hire more employees to get the job done fast. At the same time, they will purchase raw material from different companies as well. This goes on and on and this is called the multiplier effect.