A full ‘open’ economy has all sectors, and therefore, three withdrawals – savings, taxation and imports. The multiplier effect in an open economyĪs well as calculating the multiplier in terms of how extra income gets spent, we can also measure the multiplier in terms of how much of the extra income goes in savings, and other withdrawals.
Hence, the multiplier is 5, which means that every £1 of new income generates £5 of extra income. Hence, if consumers spend 0.8 and save 0.2 of every £1 of extra income, the multiplier will be: The following general formula to calculate the multiplier uses marginal propensities, as follows: For example, if 80% of all new income in a given period of time is spent on UK products, the marginal propensity to consume would be 80/100, which is 0.8. Marginal propensities show the proportion of extra income allocated to particular activities, such as investment spending by UK firms, saving by households, and spending on imports from abroad. It is important to remember that when income is spent, this spending becomes someone else’s income, and so on. The size of the multiplier depends upon household’s marginal decisions to spend, called the marginal propensity to consume (mpc), or to save, called the marginal propensity to save (mps). The multiplier effect refers to the increase in final income arising from any new injection of spending. This is because an injection of extra income leads to more spending, which creates more income, and so on. Every time there is an injection of new demand into the circular flow of income there is likely to be a multiplier effect.
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