Theory of Multiplier

7/29/2019 Theory of Multiplier

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Theory of Multiplier

Total increase in income is much larger than

the original increase in investment because

one mans income expenditure is other mans

income

K= Y

I

K= Multiplier

Y= Incremental income


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I= Incremental investment

Y = I

I I-MPCMPC= Marginal propensity to consume

K= I

MPSMPS = Marginal propensity to save.


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Multiplier : A numerical example

Round of

spending

Increase in

spending (Rs.cr.)

Cumulative Total

Initial increase 100.0 100

2 80.0 180

3 64.0 244

4 51.2 295.2


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5 41.0 336.2

6 32.8 369.0

7 26.2 395.2

8 21.0 416.2

9 16.8 433.0

10 13.4 446.4


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(Assuming MPS= 80% or 0.8%)

11 to 20combined 47.9 494.3

All others 5.7 500


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Investment multiplier= increase in GDP thatwould result from a Rs. I increase in

expenditure (say on investment by Govt) Ripple effect

Multiplier= I

I-MPCI C S

100 65 35

65 42.25 22.7542.25


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100x I = Rs.285.71

I-0.65


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Assumptions

1. MPC remains constant

2. There is no time lag between the investment and

the resultant increase in income.

3. Presence of excess capacity in consumer goodsindustries.

4. Keynesian multiplier does not fully work in

developing economies like India due to lack of excesscapacity in wage goods industries.


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Inferences of the principle of investment

multiplier

1. Govt. investment financed by borrowing (and nottaxation) could boost aggregate demand by a higheramount than initial spending

2. An increase in MPC will result in an increase in

the value of multiplier. 3. If investment is financed by tax, the multiplier

would be equal to I. It is called Balanced BudgetMultiplier.

4. It is assumed that household, do not hoardmoney.


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Leakage in the multiplier process

1. Saving is a leakage. Therefore multiplier is lessthan infinity.

2. Paying off debts

3. Holding of idle cash 4. Imports

5. Taxation-Can be offset through increase in publicexpenditure

6. Impact of inflation/ deflation can cause a gapbetween working of multiplier in money terms andin real terms.


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Foreign Trade Multiplier is the ratio of

resulting increase in gross domestic product

(GDP) to an addition to net exports (Exports-Imports)

Trade adjusted multiplier would be smaller or

bigger depending on the role external sector(net exports) play in the economy. Higher the

export demand, higher would be foreign

trade multiplier and vice versa.


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Simple Keynesian Multiplier Model

Spend more, employ more

Run Government deficits at less than full

employment to boost employment

Run Foreign Trade Surpluses

Raise the propensity to consume

Is growth promoted by equality orinequality?


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How do we alter propensity to consume?

Social safety net

Wealth effect


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Limitations of the Multiplier

1. Leakages from the incomestream:

2. Availability of consumer goods:

3. Time lags:

4. Full employment ceiling:

5. Effect of induced consumption

on investment:


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Multiplier and Underdeveloped

Economies

1. Involuntary unemployment:

2. Elastic supply:

3. Excess capacity in consumer goodsindustries:

4. Elastic supply of capital:


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My conclusion, therefore, is that

multiplier principle as enunciated by

Keynes does not operate in regard tothe problem of diminishing

unemployment and increasing output in

an underdeveloped economy, anincrement of investment based on

deficit financing tending to lead more to

an inflationary rise in prices than to anincrease in output and employment.

V.K.R.V Rao


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Theory of Multiplier