Final answer:
The multiplier effect describes how an initial increase in spending leads to a greater overall increase in national income and consumption. An example is an initial government spending of $100 leading to a total aggregate expenditure increase of $213, reflecting a multiplier of 2.13. This concept is vital in economic planning and policy-making.
Step-by-step explanation:
Understanding the Multiplier Effect
The term multiplier effect refers to the phenomenon where an increase in spending (investment, government spending, exports, etc.) leads to an increase in national income and consumption greater than the initial amount spent. To illustrate, consider a government implementing a policy that increases spending by $100. This injection of money goes into the economy and becomes someone's income, who then spends a portion of it, creating income for someone else, and thus the cycle continues. Due to tendencies to save, pay taxes, and purchase imports, each 'round' of spending is less than the previous one, but the total increase in expenditure ends up being more than the original investment.
In our example, the first round of government expenditure causes a $100 rise in aggregate expenditure. The recipients of this money will then save, spend, and pay taxes out of this income. Let's say that they end up spending $53. This $53 will form part of another person's income, which they, in turn, will save, spend, and pay taxes on. This process repeats, decreasing in magnitude each time due to the leakage into savings, taxes, and imports. The overall increase in the aggregate expenditure, on the basis of our example, is $213. Hence, the multiplier effect here is calculated as the ratio of the total change in aggregate expenditure to the change in investment ($213/$100), thus yielding a multiplier of 2.13.
This concept is crucial in understanding how economies can grow or be stimulated through various means of injections into the economic cycle. It is also significant in policy-making and economic planning, as it showcases the indirect advantages of additional spending in an economy.