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Multipliers and the Interconnectedness of the Economy

Interconnectedness

In order to understand what multipliers are, it is necessary to understand the interaction that takes place between the various industries that make up the local economy. The local economy consists of interrelated parts that depend upon one another for the production of output. Industries producing goods and services to meet a change in demand must purchase goods and services from other industries within the economy. Therefore, a change in demand within one industry group affects multiple industries within the economy. The effects on the economy as a result of an initial change in demand consist of the following components:

• Direct Effects: The purchases in the industries to which a change in final demand has occurred.
• Indirect Effects: The changes in inter-industry purchases as they respond to the demands of the directly affected industry.
• Induced Effects: Changes in spending from households as wages and salaries increase or decrease due to changes in production.

To illustrate the economy's interconnectedness and the various purchases that occur within this system of interdependence, suppose Industry A produces cars and households demand more cars. Industry A must increase production of cars in order to meet this increase in final demand. In order for Industry A to produce more cars it must purchase steel from Industry B (direct effects).

Industry B must increase its production of steel. In order for Industry B to produce more steel, it must purchase iron ore from Industry C (indirect effects). These indirect purchases continue until "leakages" (imports, wages, profits, etc.) stop the cycle.

The increased production within industries A, B, and C result in increased earnings for workers. Workers spend these increased earnings on various good and services within the economy (induced effects).

What are multipliers?

Multipliers capture the direct, indirect, and induced effects associated with a change in demand and summarize the total impact upon the economy as a result of an increase in activity within one area of the economy. In the example, increased production from Industry A causes ripple effects throughout the economy. Our studies contain two types of multipliers: income multipliers and employment multipliers.

Income Multipliers

The income multiplier estimates the total (direct, indirect, and induced) change in income that results from an increase in income within the industry where a change in final demand has occurred.

Consider Industry A from the previous example. Assume that Industry A has an income multiplier of 1.8. For every dollar of income directly generated by Industry A, other sectors within the economy generate an additional $.8 of income. If the initial change in demand that occurs to Industry A results in an increase of $1,000,000 (direct) of income, then other sectors within the economy generate an additional $800,000 (indirect and induced) of income. Therefore, the initial change in demand generates a total of $1,800,000 (1.8 * $1,000,000) of income.

Employment Multipliers

The employment multiplier estimates the total (direct, indirect, and induced) change in employment resulting from an increase in employment within the industry where a change in final demand has occurred.

Assume that Industry A has an employment multiplier of 1.75. For every one job created within Industry A, other sectors within the economy generate an additional .75 jobs. If the initial change in demand that occurs to Industry A results in an increase of 1,000 (direct) jobs, then other sectors within the economy generate an additional 750 (indirect and induced) jobs. Therefore, the initial change in demand generates a total of 1,750 (1.75 * 1,000) jobs.

Updated: December 10, 2002

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