The spending multiplier calculator is a tool that lets you calculate the spending multiplier using marginal propensity to consume (MPC) or marginal propensity to save (MPS).
In this article, you will find out what the spending multiplier is, discover the investment spending multiplier formula, and see our simple spending multiplier calculator in action.
What is a spending multiplier?
In finance, a multiplier is a factor that, when changed, causes other factors to change.
A multiplier effect takes place when the increase in said factor causes a disproportional increase in other related factors.
In other words, multipliers most commonly refer to increases in cash spending/investments greater than a proportional increase in the "cash base" - creating growth opportunities and snowball effects.
One example of a multiplier is the subject of this article - the spending multiplier. Another example is the money multiplier, where changes in the money supply cause changes in the monetary base of the central bank.
The exogenous spending multiplier, or just the spending multiplier, shows the concept that any increase in spending results in a more than proportional increase in the national income (GDP). People also know this effect as the investment spending multiplier, or simply the investment multiplier.
More specifically, when we want to see only the effect of the increase in government spending on the economy, we would look at the fiscal multiplier.
Right now, you must be thinking something along the lines of: "How come this increase in spending can create a disproportional increase in income? Isn't it generating money out of nothing? Has money started growing on trees? How does this all work?"
Let us explain. The concept of a spending multiplier is based on the mechanism that an initial increase in spending leads to an increase in the income of the participants of the economy. This increased income is partially spent on consumption, which, in turn, leads to a further increase in income, and the cycle repeats. Thus, the overall increase in national income (GDP) is higher than the amount of initial spending. As a side effect GDP per capita also grows.
What happens to the rest of the income? The portion of income that does not get spent on consumption goes into savings.
How does this translate to real life? Imagine this, Jack spent $1000 a on a laptop from a store. The store owner received $1000 and used $900 of this money to buy new chairs for his office. The chair maker then used $200 to buy food for his family and another $300 to fix his car and so on.
In simple terms, this all means that a portion of the initial money is put to work multiple times, thus generating additional value. The spending multiplier helps calculate exactly how much additional value is created. The next section will cover how to find the portion of income that gets spent on consumption (reinvested) and explain how to calculate the spending multiplier using the investment spending multiplier formula.
Spending multiplier formula
The formula to compute the spending multiplier is actually quite simple. As we previously mentioned, the initial spending is converted into income by the participants of the economy. This, in turn, is partially spent on consumption (gets reinvested), and the rest is saved. Before we get to the spending multiplier formula, we need to figure out how to estimate those values. To do so, you need to know the marginal propensity to consume (MPC) and the marginal propensity to save (MPS). Marginal propensity to consume shows the proportion of additional income that goes towards spending. On the other hand, marginal propensity to save shows the proportion of additional income that is not spent, and is instead saved. Since the income can be either spent or saved, it means that:
MPC + MPS = 1,
- 1 represents all of the additional income.
- MPC is the marginal propensity to consume - the proportion of the additional income that gets consumed.
- MPS is the marginal propensity to save - the proportion of the additional income that gets saved.
- both MPC and MPS are positive numbers greater than 0 and less than 1.
To easily wrap your head around it, think of it in terms of percentages. In this case, MPS would be the percentage of income that gets spent, and the rest is saved. Together MPS and MPC equal 100%.
MPC and MPS vary from country to country. Remember that while MPC and MPS are estimated for the whole economy (for example, of a country), they are also different for each player of the economy. For example, a younger person typically does not think much of savings and thus spends most of their income, leading to a higher MPC than the average adult.
The investment spending multiplier formula is closely related to MPC and MPS. The higher the MPC, the greater the proportion of income that gets consumed and reinvested, resulting in a higher spending multiplier. The spending multiplier formula is as follows:
Spending multiplier = 1 / (1 - MPC)
MPC + MPS = 1:
Spending multiplier = 1 / MPS
Now that you know what the formula to compute the spending multiplier is, let's see how this all works in practice with an example!
How to calculate the spending multiplier - an example
Let's see how to calculate the spending multiplier with an example. Business X is growing rapidly, and is investing nearly all of its income, so its marginal propensity to consume (MPC) is 0.85. Remembering that MPC + MPS equals 1, we find out that the MPS is 0.15. What is the spending multiplier in this case? Using the formula to compute the spending multiplier, our numbers give us:
Spending multiplier = 1 / (1 - 0.85) = 6.(6).
Let's double-check with the alternative formula:
Spending multiplier = 1 / 0.15 = 6.(6).
So the spending multiplier is equal to 6.(6), meaning that each additional dollar spent by Business X is going to generate about 6.7 additional dollars for the economy.
Let's expand our example a bit and see how the spending of Business X affects the economy as a whole. A good measurement would be to check the increase in GDP (Gross Domestic Product). Business X is located in the fictional paradise of San Escobar. The GDP in San Escobar is equal to $25,000,000.00. Business X spends $7,500, and the spending multiplier is 6.(6), as previously calculated. To calculate the actual increase in GDP, we need to multiply the spending by the spending multiplier. That means that the actual increase in GDP would be:
Actual increase in GDP = $7,500 * 6.(6) = $50,000
This means that the $7,500 spent by Business X generated a $50,000 increase in the GDP of San Escobar.
From there we can calculate the new GDP:
Total GDP = $25,000,000 + $50,000 = $25,050,000,
This example helps you see the potential effect that the spending multiplier can have on an economy. Our calculator has a handy section showing exactly this. Once you calculate your spending multiplier, enter the value of spending and GDP to see the multiplier effect in action.
If this example interested you, and you want to know more about how to calculate GPD growth rate, check out our GDP growth rate calculator.