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Decoder: The 'multiplier effect'

Employee adds to growth on bar chart.

TEXT OF STORY

Tess Vigeland: Congress will keep wrangling over the economic stimulus plan this week. President Barack Obama upped the pressure on lawmakers. He said the bill isn't perfect, but that the failure to act would turn the economic crisis into a catatrosphe.

He's been trying to sell the idea that all this massive government spending is worth it. In part, because of something called a multiplier effect. You'll be hearing this term a lot: Multiplier. But, what does it mean?

Reporter Sally Herships has the answer in today's Marketplace Decoder.


Sally Herships: The multiplier effect is all about spending and generating a return for the economy. Justin Wolfers is a professor of business and public policy at Wharton. He says, say the government builds a bridge:

Justin Wolfers: The money it spends turns out to be income for someone else say a construction worker, that construction worker with his or her greater income will maybe go and buy more groceries.

The grocery store owner now has more income.

Wolfers: Maybe he'll need to hire extra cashiers.

And maybe they'll all need to go and buy new clothes.

Wolfers: And so on.

So the multiplier is simply the way the government's spending ripples through the economy. Say you drop a stone in a pool. The first wave is like the money the government pays our construction worker. The subsequent ripples are weaker but they spread across a wide area. Justin Wolfers says Obama's economic experts are estimating the multiplier, or the sum of those subsequent ripples, will be 1.6 times the initial amount.

Wolfers: So government spending has a multiplied effect on gross domestic product. The overall effect is going to be bigger then the initial effect.

The administration's talking about spending almost a trillion dollars. It's hoping that'll generate $1.6 trillion throughout the economy. But Wolfers says no one's sure that'll happen.

Wolfers: We're tremendously uncertain about it. We economists are always both absolutely friendly and always at war. What is the multiplier? Is it zero? Is it five? Or does it lie somewhere in between and as a result how big should this stimulus package be?

You've got to get the initial spending number right Wolfers says. If it's too small, the economy may not budge. But if the number's too large, and the government doesn't have the cash on hand, well back to our imaginary bridge for a moment.

Wolfers: In order to fund that bridge the government's going to have to borrow money. If the government's borrowing money it may be that there's less money available for the private sector to borrow.

And taking money out of the mouths of the private sector will crimp growth, which isn't multiplying anything.

I'm Sally Herships for Marketplace Money.

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