Concept of Multiplier - Economics

John Maynard Keynes, 1919 and 1945

CONCEPT OF MULTIPLIER

THE AGGREGATE DEMAND IS COMPOSED OF :

1. CONSUMPTION DEMAND

2. INVESTMENT DEMAND

FROM THE CONCEPT OF MULTIPLIER IT IS KNOWN HOW MUCH OR HOW MANY TIMES INCOME INCREASES AS INVESTMENT IS DONE.

AS INVESTMENT INCREASES NATIONAL INCOME INCREASES PROPORTIONATELY MUCH MORE.

HOW MANY TIMES IT INCREASES DEPENDS ON MPC.

HIGHER THE MPC THE NATIONAL INCOME WILL BE GREATER DUE TO INVESTMENT.

MARGINAL PROPENSITY TO CONSUME

RATIO OF CHANGE IN CONSUMPTION TO CHANGE IN INCOME INDICATE THAT PART OF ADDITIONAL INCOME WHICH IS NOT SPENT ON CONSUMPTION.

EG. NATIONAL INCOME = 1200CR FROM 1000CR

CONSUMPTION EXPENDITURE = 900CR FROM 800CR

MPC = 100/200 =.5

INVESTMENT

THAT PART OF INCOME WHICH IS USED FOR FURTHER PRODUCTION EXPENDITURE MADE FOR THE CREATION OF NEW CAPITAL ASSETS LIKE MACHINE, TOOLS, BUILDING ETC.

TYPES OF INVESTMENT –

AUTONOMOUS INVESTMENT PRIVATE OR PUBLIC INVESTMENT INDUCED INVESTMENT

The Keynesian system: Planned and actual investment

Investment has three components:

• Plant and equipment -- drill presses, factory buildings, etc.

• Residential investment -- new housing construction

• Inventory investment -- Change in Business Inventories

.

The Consumption Function: the key to Keynes

Consumption depends on the level of DISPOSABLE

INCOME (disposable personal income = income -

taxes = Y - T)

Some consumption is autonomous (= “independent” of

DPI): it may depend on other factors such as

wealth or stock values. (even at zero income, Bill

Gates would consume something)

The consumption function proposed by Keynes is:

C = C0

+ Cy ( Y - T)

C0

= Autonomous consumption

Cy

= Marginal propensity to consume

The marginal propensity to consume plays a

central role in the Keynesian system. Keep your eye on

the MPC in the following slides.

MULTIPLIER• CHANGE IN INVESTMENT LEADS TO CHANGE IN

NATIONAL INCOME

CHANGE IN NATIONAL INCOME IS A MULTIPLE OF CHANGE IN INVESTMENT

THIS MULTIPLE IS TERMED AS MULTIPLIER OR INVESTMENT MULTIPLIER

INVESTMENT MULTIPLIER IS A MEASURE OF CHANGE IN NATIONAL INCOME AS A RESULT OF CHANGE IN INVESTMENT.

EG. NATIONAL INCOME INCREASES BY 300CR AS A RESULT OF INCREASE IN INVESTMENT OF 100CR

K=3(300/100)

ASSUMPTIONS OF MULTIPLIER

THERE IS AUTONOMOUS INVESTMENT IN ECONOMY

MARGINAL PROPENSITY TO CONSUME REMAINS CONSTANT

CONSUMPTION IS THE FUNCTION OF CURRENT INCOME

NO TIME LAG BETWEEN RECIEPT OF INCOME AND ITS DISPOSAL IN FORM OF CONSUMPTION

NET INCREASE IN INVESTMENT

SUPPLY OF CONSUMER GOODS IS ALWAYS IN ECONOMY

FEATURES OF MULTIPLIER

IT IS ASSOCIATED WITH CHANGE IN INVESTMENT

SIZE OF MULTIPLIER DEPENDS UPON SIZE OF MPC

MULTIPLIER WORKS IN BOTH FORWARD AND BACKWARD DIRECTION

VALUE OF MULTIPLIER VARIES FROM UNITY TO INFINITY

SIZE OF MULTIPLIER

HIGHER THE MPC –LARGER THE MULTIPLIER SIZE

LARGEST POSSIBLE MPC IS UNITY

IF MPC IS ZERO MULTIPLIER IS UNITY

K=1/1-MPC THAT IS RECIPROCAL OF MARGINAL PROPENSITY TO SAVE

USES OF MULTIPLIER

TOOL OF ANALYSYING GROWTH, PLANNING, PROJECTING, INVESTMENT REQUIREMENT

TOOL FOR ACHIEVING TARGETED GROWTH RATE, IF MPC IS GIVEN

TOOL FOR ANALYSING THE FLUCTUATIONS IN THE ECONOMY

IMPORTANT TOOL FOR ANALYSING IMPACT OF TAXATION, FOREIGN TRADE ON THE ECONOMY

LIMITATIONS OF A MULTIPLIER

MULTIPLIER DEPENDS ON A LARGE NUMBER OF FACTORS ALONG WITH MPC

EFFICIENCY OF PRODUCTION REGULAR INVESTMENT MULTIPLIER PERIOD FULL EMPLOYMENT CEILING ASSUMPTION THAT GOODS AND SERVICES ARE AVAILABLE IN

ADEQUATE SUPPLY GOODS AND SERVICES CANNOT BE PRODUCED IN EXCESS OF

THEIR FULL EMPLOYMENT LEVEL

IMPORTANCE OF MULTIPLIER

USEFUL TO ANALYZE PUBLIC INVESTMENT

REMOVES DEPRESSION THROUGH GOVERNMENT INVESTMENT

ACHIEVING FULL EMPLOYMENT

MARGINAL EFFICIENCY OF CAPITAL EMPLOYMENT RISES

PRIVATE INVESTMENT ENCOURAGED

3 CONCEPTS OF MULTIPLIER

STATIC MULTIPLIER

COMPARATIVE STATIC MULTIPLIER

DYNAMIC MULTIPLIER

EMPLOYMENT MULTIPLIER

PROPOUNDED BY KAHN

GOVERNMENT UNDERTAKES PUBLIC WORKS,THIS LEADS TO INITIAL AND PRIMARY EMPLOYMENT.

THIS RESULTS IN INCREASE IN DEMAND FOR CONSUMPTION GOODS WHICH IN TURN PROVIDES MORE EMPLOYMENT.

MULTIPLIER AND UNDERDEVELOPED

COUNTRIES

Does not applies to underdeveloped

countries like India.

REASONS:

1.DEMANDS CAN BE MET EASILY IN

DEVELOPED COUNTRIES.

2.SUPPLY OF RAW MATERIALS IS ELASTIC

IN DEVELOPED COUNTRIES.

3.THERE IS NO INVOLUNTARY

EMPLOYMENT.

LEAKAGES IN INCOME STREAM AND THEIR

EFFECT ON MULTIPLIER

PAYING OF DEBTS

IDLE CASH BALANCES.

IMPORTS.

PURCHASE OF EXISTING SECURITIES.

PRICE INFLATION

Keynesian equilbrium: Solution procedure

Start with the equation in general form:

Y = C0 + Cy ( Y - T) + Ip + G + NX

Substitute in the given numbers:

Y = 300 + 0.8 ( Y - 1000) + 1500 + 1200 + 500

Collect all the constant terms:

Y = 3500 + 0.8Y - 800

Y = 2700 + 0.8Y

Subtract 0.8 Y from both sides of the equation:

0.2 Y = 2700

Finally, multiply both sides by 1 / 0.2 = 5

Y = 5 (2700) = 13, 500

The Multiplier

Rerun the previous exercise, raising planned investment by 500.

Y = 300 + 0.8 ( Y - 1000) + 2000 + 1200 + 500

Collect all the constant terms:

Y = 4000 + 0.8Y - 800

Y = 3200 + 0.8Y

Subtract 0.8 Y from both sides of the equation:

0.2 Y = 3200

Finally, multiply both sides by 1 / 0.2 = 5

Y = 5 (3200) = 16, 000

GDP is UP BY 2,500, NOT up by only 500.

Investment spending has a MULTIPLIER EFFECT of 5