In macroeconomics, a multiplier effect occurs when small changes in investment or government spending lead to much larger changes in total output. Economists use multipliers to assess the additive effects of a government's fiscal and monetary policy on the economy. The expenditure multiplier measures the effects that changes in public and private expenditures have on the economy. The money multiplier shows how each additional dollar of reserves contributes to the additional amount of money the banking system.
Economists calculate the expenditure multiplier by measuring the marginal propensity to consume or MPC, and the marginal propensity to save, or MPS. MPC is determined by the ratio of the change in consumption to the change in disposable income, while the marginal propensity to save is determined by the ratio of the change in savings to the change in disposable income. MPC plus MPS always equals 1. The expenditure multiplier is 1 divided by the MPS, or 1 divided by (1-MPC).
Since the expenditure multiplier and the MPS have an inverse relationship, a small MPS gives a large expenditure multiplier and vice versa. This means that, when people are less likely to save as their disposable income increases, they are more likely to consume at higher levels, which promotes economic growth. When people save more as they have more disposable income, the expenditure multiplier shrinks, which brings about economic recession and decreased production.
The money multiplier equals the reciprocal of, or 1 divided by, the reserve requirement. The reserve requirement is the percentage of deposits that the Federal Reserve requires all banks and similar financial institutions that operate in the United States to have on reserve as deposits with the Fed. For instance, if the Fed requires banks to keep 10 percent of every dollar deposited on reserve with the Fed, the money multiplier is 1/0.1, or 10.
The money multiplier works to its greatest effect when the Federal Reserve (or other central bank) seeks to boost the money supply. Instead of flooding the economy with more money, which can spur inflation, the central bank can increase the money supply by a small amount and allow the money multiplier to enhance the process. For instance, instead of placing $100 million in new currency into circulation, the central bank can insert $10 million and use a current money multiplier of 10 to the same effect.