I read a very interesting article written by Stephen Mulholland in FinWeek in October. He talks about a concept that I remember studying in Economics called the multiplier effect. I’ve adapted this article from what he had to say in FinWeek for the blog.
Take a read, I would appreciate your comments.
A salesman arrives at a hotel and requests a room for the night. The landlord quotes him R100 and the salesman accepts. The salesman requests to pay in advance because he is leaving early and settles the R100 bill there and then. He then goes for a drink in the bar.
The landlord calls her son and instructs him to take the R100 and to go and give it to the baker down the road to settle her account there. The baker accepts the R100 as settlement and then duly instructs his assistant to please take the R100 and go give it to the butcher because the bakers account at the butcher is outstanding by R100.
The butcher accepts the R100 and then asks his wife to please go to the hotel and pay the R100 to the landlord because there is R100 outstanding on his tab at the hotel bar. The landlord accepts the R100 from the butcher as settlement for the account.
The salesman then comes down to the landlord and explains to the landlord that he has been called away urgently and could he please be refunded the R100. The landlord obliges and the salesman leaves with the R100 in his pocket.
Here we have R100 circulating and then disappearing but leaving several debts satisfied.
I would appreciate your comments.
The multiplier effect is a tool used by governments to restimulate aggregate demand. This can be done in a period of recession or economic uncertainty. The money invested by a government creates more jobs, which in turn will mean more spending and so on.
For example: a company spends R1 million to build a factory. The money does not disappear, but rather becomes wages to builders, revenue to suppliers etc.
The builders will have higher disposable income as a result, so consumption, hence aggregate demand will rise as well.
Say that all of these workers combined spend R2 million dollars in total, since there was an initial R1 million input which created a R2 million output, the multiplier is 2.
If it were only that simple. These days there is so much leveraged on the R100 in the way of finance and transactional charges. If the culprits of the sub prime crisis realized how intricately we are all linked, they may have been more cautious.