It is useful to think of a local economy as an entity which trades with other local economies. People and firms in a local economy "earn" money for the local area in two ways. First, money is earned by selling products and services to buyers outside the local area. These sales are called "exports." Second, money is earned by having dollars re-spent on local products and services.
Once inside the local economy, dollars "leak" to outside economies in three possible ways. First, dollars spent on goods and services purchased from outside the local area flow to outside economies. These purchases are called imports. Second, dollars leave the local economy when taxes are paid to national and state governments. Third, dollars flow outside the local economy when investments are made outside the local area.
Figure 1. The Local Economy
Figure 1 illustrates this concept of a
local economy. Dollars flow into the local economy from the sale of "exports," and
dollars are created when local residents purchase locally produced products and services. Dollars
leave the local economy when imported inputs are bought and when national and state taxes are
paid and outside investments are made.
Let's consider in more detail what
happens when dollars are spent on locally produced goods and services. Consider this example.
Say a local factory experiences an increase in its sales outside the local economy. This means an
increase in "exports" and an increase in dollars flowing into the local economy. These
new dollars will go into the pockets of the factory owners, managers, and workers. These local
residents will see an increase in their income.
But the process won't stop there. The
factory owners, managers, and workers will use the new dollars to pay taxes, to make
investments, to buy goods and services produced outside the local economy, and to buy goods
and services produced inside the local economy. New dollars which are used to pay national and
state taxes, which are used to purchase investments outside the local economy, and which are
used to purchase goods and services produced outside the local economy are lost to the local
economy. That is, these dollars "leak" to outside the local economy.
But the new dollars which are spent on
locally produced goods and services create a "ripple" effect in the local economy.
When one of the factory workers with "new" dollars spends some of those dollars in
local restaurants, local supermarkets, and local malls and departments stores, these dollars
become income to the owners and workers in those enterprises. Likewise, these owners and
workers in local restaurants, supermarkets, and other shops will, in turn, spend some of their
"new" dollars on locally produced goods and services, so these dollars become
income a third time to other local citizens.
Figure 2. Development of a Multiplier.
Figure 2 illustrates this process. Round
1 shows an initial new dollar of income coming into the local economy from, for example, the
increase in outside sales for the local factory. If 60 cents (or 60%) of this dollar is
"leaked" outside the local economy via outside taxes, outside investments, and goods
and services purchased from outside the local economy, then 40 cents (40%) will be re-spent
locally. This is shown in Round 2.
If, again, 40% of all income is re-spent
locally, then 40% of the 40 cents in Round 2 will be spent again in the local economy. This
results in 16 cents (.40 x 40 cents) being re-spent locally and 24 cents (.60 x 40 cents) of leakage
in Round 3.
The process continues as shown in
Figure 2. Although six rounds of spending are shown in the figure, the process can go on
indefinitely. However, the dollar amounts become progressively smaller in later rounds.
What, then, is the total amount of new
income which occurs in a local economy from each initial new dollar of earned income? The
answer can be found for the example in Figure 2 by adding the new income at each of the six
rounds. That is, the total amount of new income is the sum of:
$1.00 from
Round 1
+ $0.40 from Round 2
+ $0.16 from Round 3
+ $0.06 from Round 4
+ $0.02 from Round 5
+ $0.01 from Round 6
= $1.65 of new income.
So, in our example, $1.65 of new
income and spending results from each initial new $1.00 of earned income. The ratio of $1.65 to
$1.00 is 1.65. The number 1.65 is called the "income multiplier." The income
multiplier can be used to estimate the total amount of new local spending resulting from an initial
increase in
local income. If, in our example, the local factory sees its sales to outside the area increase by
$100,000, and
if the income multiplier is 1.65, then the estimate of new local spending is $100,000 x 1.65, or
$165,000.
SIZES OF MULTIPLIERS
USING MULTIPLIERS
The formulas for using the income and employment multipliers are:
There are two commonly used
multipliers. One is the income multiplier which was explained above. The second is the
employment multiplier. The employment multiplier works the same way as the income multiplier.
If the initial number of new jobs created by, say, an existing factory in the local economy
expanding or a new business moving to the local area, is multiplied by the "employment
multiplier," then the result is the total new employment in the local economy.
How big are these income and
employment multipliers? Sometimes claims are made that income multipliers are in the range of 5
to 7, meaning that $5 to $7 total dollars of income and spending are created in a local economy
from each new dollar of initial spending. Such ranges for the income multiplier are totally out of
line! A tremendous amount of "leakage" occurs in local economies, because most
local economies "import" a significant amount of their goods and services.
Table 1 gives average income and
employment multipliers for North Carolina communities. The multipliers differ by industry
because each industry has a slightly different structural relationship with other industries and hires
a different number of workers per dollar of sales.
As can be seen in Table 1, most of the
income multipliers are in the range of 1.5 to 2.5. Most of the employment multipliers are in the
range of 20 to 40 employees per $million in sales.