In today’s post, we will be discussing income multiplier effect. The multiplier is the change in income that arises from changes in injections into the economy. Injections into the economy come in many forms, examples include government spending on roads, firms investing in new machinery, and outsiders buying groundnuts that are produced in the country. The idea of the multiplier is that whenever there are injections the economy, the overall impact of the spending (injection) on the economy will be more than the initial spending.
To illustrate this idea, suppose that the government of The Gambia wants to build a road that costs GMD100 million. The government will give the job to a company and then the company will hire workers to construct the road. The workers will be paid salaries for their job. Once the workers receive their salaries, they in turn will spend at least part of their salaries on household expenditure and the rest will be saved. The spending the workers do will serve as incomes for say, market vendors who in turn will use their income to purchase other goods and services. This process of spending will ripple in the economy and give rise to extra expenditures that is beyond the initial GMD100 million spent in building the road. While there are injections in the economy, there are also leakages, that is, money leaves the flow through taxation from government, savings and spending on imported goods and services. The size of the multiplier depends crucially on these leakages or withdrawals.
To illustrate the multiplier effect, we use data on national income from the Penn World Tables that provide yearly data on Gross Domestic Product (GDP) or national income, consumption expenditure, and spending on importation of goods and services. Additionally, we use data on tax on income and wealth that is published by the Central Bank of The Gambia (CBG). Figure 1 below plots national income, private consumption and expenditure on imported goods expressed in millions of Gambian Dalasi (GMD) for the periods 1960-2017. As expected, national income (blue line) is higher than consumption expenditure (red line) which in turn is higher than expenditure on imports (green line).
Figure 1: National Income, Consumption and Imports Expenditure (1960-2017)
Using the above series, we can estimate the multiplier of the country. The multiplier is given by the inverse of the sum of the three sources of leakages; savings, imports and taxes The first component is called the marginal propensity to save (MPS). The marginal propensity to save is defined as the amount that is saved for every additional GMD earned by a consumer. For example, if every GMD100 earned, GMD75 is consumed and the remaining GMD25 is saved, then the MPS is 0.25. Similarly, the marginal propensity to consume is 0.75 or 1-MPS. The second component is the marginal propensity to import (MPM), that is for every GMD earned, how much is spent on goods and services that are imported. Finally, the last component of the withdrawals is due to taxation from government also known as the marginal propensity to tax (MPT).
To compute these components, we use data and run a simple regression of consumption, imports, and taxes on national income (GDP). A regression of consumption expenditure on national income provides an estimated marginal propensity to consume of 0.74. This number implies that on average for every additional GMD that is earned, 74 bututs is spent on consumption and the remaining 26 bututs is saved. Similarly, a regression of imports on national income reveals an estimated marginal propensity to import of 0.13; for every GMD1 increase in income, 13 bututs are spent on imported goods and services. Finally, the marginal propensity to tax is 0.03. Combining these estimates, we can finally estimate the income multiplier as 1/[1-(MPS+MPM+MPT)] = 2.38.
So what does this number mean? As explained earlier, the multiplier simply gives us how much an initial increase in spending multiplies as it changes hands in the economy. Now let us return back to our first hypothetical example of the government contracting a company to construct a road that costs GMD100 million. Applying the computed multiplier, this expenditure will lead to a final increase in income by about GMD238 million (2.38 by GMD100 million).