To fully explain the multiplier effect, we need first to define the Injections and Withdrawals, preferably through the model of Circular flow of income:
It is a simple economic model describing a circulation of income between producers (firms) and consumers (households.). It consists of direct inner flow between firms and households and outer flow. The outer flow is caused by the fact that households do not spend all of their income on consumption; part of their income is withdrawn as net savings, Net taxes and Import expenditure. This happens through another three agents: Banks, Government and Abroad. These agents also represent part of the demand for firm’s output. It is an additional component of aggregate demand called injections. We divide three types of injections caused by these agents: Investment (by banks), Government expenditure (government) and Export expenditure (by abroad)
In the first case of an increase in government spending, we will talk about the injection multiplier as this extra money spent represents injection into the economy. This rise in injections will cause national income to rise. The number of times that the increase in income is greater than the increase in injections is known as injection multiplier: The multiplier (k) is defined as:
where Y is national income and J is injections, which consist of investment (I), government expenditure (G) and the expenditure on exports (X). The multiplier measures the rise in Y resulting from a single period injection after an infinite number of rounds. According to this equation, if a 10 million rise in injections caused a 40 million rise in national income, the multiplier would be 4.
The main cause of multiplier effect is that when extra money is injected into the economy of the country, it will stimulate more spending, which will stimulate even further spending and so on. For example, let’s assume that firm decided to invest more money. This, in turn, will lead to more...