What is the multiplier effect?

The multiplier effect refers to the phenomenon where an initial increase in spending (an injection into the economy) leads to a larger overall increase in income and economic activity. This occurs because when an entity, such as the government or a business, spends money, it creates income for others, who then spend a portion of that income, generating further income for even more people. Each subsequent round of spending creates additional income, which continues to circulate within the economy.

For example, if the government invests in infrastructure, it pays contractors who then pay their workers. Those workers then spend some of their earnings on goods and services, benefiting other businesses. The cycle continues, leading to a total increase in economic activity that is greater than the initial amount spent.

The other options represent different economic concepts. The increase in interest rates due to inflation relates to monetary policy, the decline in supply due to higher production costs pertains to supply-side economics, and balanced government budgets are discussed in terms of fiscal policy but do not capture the essence of the multiplier effect. The correct understanding of the multiplier highlights the interconnectedness of spending and how it amplifies overall economic growth.