The Keynesian Multiplier Effect

What this diagram shows

The multiplier effect diagram shows two rightward shifts of aggregate demand. An injection such as a £10bn rise in government spending first shifts AD from AD1 to AD2 by the amount of the injection. That spending becomes income for workers and firms, who spend part of it; each round of induced consumption creates further income, but a proportion leaks out as withdrawals (saving, taxation and imports), so each round is smaller than the last. The sum of these further rounds shifts AD again, from AD2 to AD3. The total shift, AD1 to AD3, equals the multiplier (k = 1/MPW) times the injection: with an MPW of 0.4, k = 2.5 and AD rises by £25bn. Real output rises from Y1 to Y2 as a result of the injection alone and from Y1 to Y3 in total. All three equilibria lie on the perfectly elastic section of the Keynesian LRAS, where the economy has spare capacity, so the price level is unchanged and real output rises by the full k times the injection (ΔY = k × ΔG). Nearer full employment the AS curve slopes upward, and part of the increase in AD would instead raise the price level.

Key points

• The diagram shows two AD shifts: AD1 to AD2 is the initial injection, and AD2 to AD3 is the induced rounds of consumption spending
• The total shift in AD (AD1 to AD3) equals the multiplier times the initial injection: ΔAD = k × ΔJ
• k = 1/MPW, where MPW = MPS + MPT + MPM; in a closed economy with no government this simplifies to 1/(1 − MPC)
• The larger the marginal propensity to withdraw, the smaller the multiplier, so open economies with high import propensities tend to have smaller multipliers
• Only where AS is perfectly elastic (spare capacity) does real output rise by the full k × ΔJ; closer to full employment, part of the increase in AD raises the price level instead
• The effect works in reverse: a fall in an injection reduces AD and real GDP by more than the initial cut