The theory of multiplier and Acceleration principle

The theory of multiplier and Acceleration principle

Vaghela Nayan K.SDJ International College

The concept of Investment MultiplierThe concept of Multiplier is developed by Prof. Keynes, and it is based on the concept of Marginal propensity to consume.It refers to the effects of changes in investment outlay on aggregate income through induced investment expenditure.The Multiplier expresses the relationship between an initial increment in investment and the final increment in Aggregate Income.Whenever an investment is made in the economy, it leads to increase in aggregate income not only by amount of investment but by somewhat more than that.The reason is that the initial investment increases the income not only in those industries where the investment is made but also in certain other industries whose products are demanded by people employed in investment industries.

For example: If initial investment increases by `10 crores and the aggregate income rises by `30 crores, then the multiplier is 3. In its essence, the Multiplier is the ratio of the change in Income to the change in Investment.Thus, Multiplier, K = Y/IK= investment multiplierY= change in incomeI = change in investment.

Determination of Multiplier

The process of Income Generation Through MultiplierAs said earlier there is a direct relationship between MPC and the value of multiplier, suppose the MPC is and apparently the value of MPS is the value of multiplier will be 4.If the initial investment in the economy is `20 crores, the it will create the total income of 20x4 = ` 80 Crores. This income generation happens in two stages:Primary generation of Income: When an additional investment of `20 crores is made for the constructions like, railway line, the different categories of people employed in this project taken together will earn an income of `20 crores. This is known as primary income.

Secondary Income Generation: now, assuming MPC , k15 crores will be spent by these people on food, clothing and other consumer goods. It means k15 crores is received as income by businessmen, shopkeepers and others. this ligic is based on the fundamental proposition that one mans consumption expenditure is another mans income. The recipients of k15 crores will be spending its part (k11.25 crores) for their consumption and so on.At the end the total income generation will be k80 crores and MPS being the total savings will be k20 crores, so that the savings will be equal to amount of initial investment. Here the process of income expansion comes to an end.This whole process of income generation is spread over a period of time. In the above example, the aggregate income does not increase to k80 crores at once and simultaneously, but over a period of time. If each round takes 5 months to generate the income than total k80 crores will be generated at the end of 25 months, as there can be five such rounds.

In the above diagram, the original equilibrium level of income is OM at point E. Now it investment is increased by AB , the new curve is C+I+I.As a result of this increase in investment, income increases by MN. This is due to multiplier effect.In the words of J. Breadshow, The multiplier principle is that a change in the level of injection bring about a relatively greater change in the level of national income.

Assumption of the concept of Multiplier:There is change in autonomous investment. (government spending, exports, etc.)There should not be any change in the marginal propensity to consume.Positive gross investment is not enough, but there should be positive net addition to societys stock of capital.There should be continuity in investment.Steady flow of consumption goods.Non existence of international trade with the rest of the world.No time lag between the income receipt and consumption expenditure made by the community.Lump-sum tax system should be implemented or the effect of multiplier will be less in case of proportionate tax system.The economy operates at the situation less than full employment. Existence of involuntary idle resources.

Leakages of Multiplier:Saving: in the situation where the MPC is 1 and MPS is zero, the entire new income generated as a result of an increase in investment would be spent by the people in buying consumer goods. Here the increase in income will last till the economy attains the stage of full employment. But in practice, MPC can hardly be 1. as people are also keen to save their part of income. Contrary if the people will save whole of their increased income, then there can not be investment multiplier. Higher the MPS lower the investment multiplier.Debt Repayment: according to Duesenberry, people use their part of income for the payment of the past debts that they have incurred. Because of this there is leakage from the income stream and the value of multiplier gets reduced.Accumulation of idle cash balance: the part of increased income saved by the people in banks (idle cash) will not be the part of money in circulation and therefore the value of multiplier will come down.

Stock exchange transactions: The income spent for purchasing of old stock, securities and bonds by the people will not form the part of consumption expenditure , therefore such transactions are unlikely to increase the value of multiplier.Imports: Money spent in buying imported goods does not add to domestic income and employment. Because of this money leaks out of the country. This limits the value of multiplier.Price inflation: During inflation, money income of the community increases but real income decreases. The real consumption expenditure which determines the value of the multiplier will fall. The major part of increase in money income will be neutralized by price inflation instead of stimulating consumption, income and employment.Taxes: If government takes away the newly generated income in the form of taxes, the value of multiplier will fall.Corporate Savings: The part of net profit not distributed as dividends and retained by the business for expansion, will also reduce the value of multiplier.

Limitations Of The Theory Of MultiplierIt is a static theory as MPC decreases with the increase in income and therefore, multiplier cannot be constant.As the behaviors of the people may change, it is difficult to project the expected consumption using past records. So, it is difficult to calculate aggregate marginal propensity to consume.Multiplier shows the process of income generation from one point of equilibrium to another, but it fails to analyze the actual sequence of events that increases the level of income.The theory is unable to explain the effects of change in income and consumption on investment.Investment multiplier do not take in to consideration the effects of derived demand. It just takes into account the induced demand of consumption goods.Ignorance of time element in the generation of income.Even the use of investment and production of goods and services for the increased demand requires time and during this gap, multiplier effect is partly lost.

If the economy operates under the situation of full employment, the multiplier concept will not be applicable as it can have the shown impact in the situation of involuntary unemployment.It is difficult to know the size of additional investment, as increased investment in public sector reduces the investment in private sector.The under developed countries are having the problem of increasing their productive capacity as they are having scarcity of factors of production. The theory of multiplier works when the country is having excess production capacity, therefore, this theory is not applicable for under developed economies.No empirical evidences.

Acceleration principleMeaning:The acceleration principle shows how changes in demand for consumption goods affect the demand for capital goods. It expresses the ratio of the net change in consumption to the net change in investment. It measures the changes in the capital goods industries consequent upon the changes in customer goods industries.The principle of acceleration states that a given increase in the demand for consumer goods leads to an accelerated demand foe investment goods.it can be expressed as a = I/Cwhere, a stands for acceleration coefficient, I is net change in investment outlay and C is net change in consumption outlay.If the net change in consumption outlay of k20 crores leads to a net increase in investment outlay of k40 cores then the acceleration coefficient will be 2.

Functioning of the acceleration principleSuppose the existing demand for consumption goods in the economy is 1000 units per year.The capital output ratio is 1:10, that is 100 units of capital goods are required to maintain a constant flow of 1000 units of consumption goods.If each of the capital goods is having a life span of 10 years, so 100 units of capital goods will wear out in 10 years therefore we need 10 machines every year by the way of replacement, so that 100 machines are kept in fact at the end of tenth year.This demand for 10 machines every year is known as replacement demand.The acceleration coefficient is one.

Now suppose that the demand for consumer goods increase by 10% next year. This means the demand for consumer goods will increase from 1000 units to 1100 units.To produce this additional 100 units of consumption goods we require additional 10 units of capital goods or machine as we have assumed the capital output ratio of 1:10.This is of course in addition to the 10 units of capital goods which are required every year for replacement purposes.Thus, the total demand for new capital goods will be10 units of capital goods for replacement.10 units of capital goods to satisfy the increased demand for consumption goods.Here, only 10 % of increased demand for consumption goods leads to 100% increase in demand for capital goods(10 units to 20 units). Here the acceleration will be 10.A small increase in consumption demand leads to a huge increase in the demand for capital goods.

It cam be seen from the above table that a cooperatively small rise of 10% in the demand for consumption goods cause a rise of 100% increase in the demand for capital goods.The acceleration principle shows that, a small change in consumption leads to a huge change in induced investment.YearConsumption demandTotal requirement of capital goodsReplacement demandNew demand for capital goodsTotal demand for capital goodsPercentage change1st year1000 units100 units10 units-10 units-2nd year1100 units110 units10 units10 units20 units100 %

Limitations of Acceleration principleUnrealistic assumption of constant capital output ratio. This is perhaps not possible because of inventions and technological progress. Arrival of new and better technology will increase the output per unit of capital.There should not be surplus capacity in the capital goods industries, or else the increase in the demand for consumption goods may be met by the better utilization of existing capital equipment rather than by fresh investment.The entrepreneurs will not increase the investment if they feel that the increase in the demand for consumption goods are of temporary nature.If the human and materials required to produce the capital goods are not adequately available, as if the economy is working in the near situation of full employment, the acceleration principle may not prove to be correct.Induced investment must also be complemented by monetary resources. In case of shortage of funds will increase the rate of interest and limits the effect of acceleration.

In several cases where investment decisions do not await for the changes in the rate of consumption. This can be in the case of public sector enterprises where long term investments are made well in advance of expected change in the level of consumption.According to Semuelson, for a study of the complete analysis of the process of income generation, we must consider both the multiplier effect as well as the acceleration effect.

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