An explanation of the Multiplier Effect

1. The Multiplier Effect
Changes in Aggregate Demand are likely to have more than one effect. This is due
to the Circular Flow of Income in which money is circulated around the economy.
Consumers Producers
In the simple diagram above the money that Consumers spend on products from
producers, is the producer’s income as well as being consumer expenditure. This is
also true for the bottom arrow, which indicates the consumers income but also the
producers expenditure.
The multiplier effect explains what happens with an increase in Aggregate
Demand. If for example consumer spending rises, this indicates that consumers are
buying more, which increases the demand for a business’s products. This causes
the business to purchase capital goods (investment) in order to cope with the
excess demand. In addition to this the companies would have to raise the wage
rate to cope with the extra demand, which then increases government revenue
and consumer spending.
This is known as the multiplier effect.
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