Tester

The basic assumption of the multiplier effect is that the economy starts off with unused resources, for example, that many workers are cyclically unemployed and much of industrial capacity is sitting idle or incompletely utilized. By increasing demand in the economy it is then possible to boost production. If the economy was already at full employment, with only structural, frictional, or other supply-side types of unemployment, any attempt to boost demand would only lead to inflation. For various laissez-faire schools of economics which embrace Say's Law and deny the possibility of Keynesian inefficiency and under-employment of resources, therefore, the multiplier concept is irrelevant or wrong-headed.

As an example, consider the government increasing its expenditure on roads by $1 million, without a corresponding increase in taxation. This sum would go to the road builders, who would hire more workers and distribute the money as wages and profits. The households receiving these incomes will save part of the money and spend the rest on consumer goods. These expenditures in turn will generate more jobs, wages, and profits, and so on with the income and spending circulating around the economy.

The multiplier effect arises because of the induced increases in consumer spending which occur due to the increased incomes -- and because of the feedback into increasing business revenues, jobs, and income again. This process does not lead to an economic explosion not only because of the supply-side barriers at potential output (full employment) but because at each "round", the increase in consumer spending is less than the increase in consumer incomes. That is, the marginal propensity to consume (mpc) is less than one, so that each round some extra income goes into saving, leaking out of the cumulative process. Each increase in spending is thus smaller than that of the previous round, preventing an explosion.