Every time there is an injection of new demand into the circular flow there is likely to be a multiplier effect. This is because an injection of extra income leads to more spending, which creates more income, and so on. The multiplier effect refers to the increase in final income arising from any new injection of spending.
Consider a £300 million increase in business capital investment – for example created when an overseas company decides to build a new production plant in the UK. This will set off a chain reaction of increases in expenditures. Firms who produce the capital goods that are purchased will experience an increase in their incomes and profits. If they in turn, collectively spend about 3/5 of that additional income, then £180m will be added to the incomes of others.
At this point, total income has grown by (£300m + (0.6 x £300m).
The sum will continue to increase as the producers of the additional goods and services realize an increase in their incomes, of which they in turn spend 60% on even more goods and services.
The increase in total income will then be (£300m + (0.6 x £300m) + (0.6 x £180m).
The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow.
The 3/5th of the additional income spent is also known as the marginal propensity to consume (MPC). In this case the MPC is equal to 0.6.
The following general formula to calculate the multiplier uses marginal propensities, as follows:
Multiplier = 1/ (1-mpc)
Hence, if consumers spend 0.6 and save 0.4 of every £1 of extra income, the multiplier will be:
1 / (1-0.6) = 1/0.4 = 2.5
Hence, the multiplier is 2.5, which means that every £1 of new income generates £2.5 of extra income.