Multiplier Effect

The Concept…..The concept of multiplier was first developed by

F.A.Kahn in the early 1930s. The concept was later refined by Keynes.

F.A.Kahn developed the concept of multiplier with reference to the increase in employment,direct as well as indirect,as a result of initial increase in investment and employment.

Later on Keynes propounded the concept of multiplier with reference to the increase in total income,direct as well as indirect,as a result of original increase in investment and income.

Cont…..Kahn’s Multiplier is known as “Employment

Multiplier” and Keynes multiplier is known as “Investment or Income multiplier”.

The Value of Multiplier or k = 1/1-MPC

Assumptions for Multiplier EffectThe marginal propensity to consume remains

constant throughout as the income increases.There is a net increase in investment over the

preceding year.There is no any “time-lag”between the

increase in investment and the resultant increment in income.

Excess capacity exsists in the consumer good industries.

Shift in Aggregate Demand and MultiplierIn the two-sector model, a change in

aggregate demand is caused by a change in consumption expenditure or in business investment or in both.

Consumption expenditure is however more stable function of income.

A change is assumed in the aggregate demand function due to a change in the business investment.

I

I

45

(-)S

0

Expenditure

income

I

Y2Y1

M

k C= a+ by

C + I

C+I+C + S

E2

E1

I

S

I+ I

J

Y

Importance of MultiplierTo explain the cumulative upward and

downward swings of trade cycles that occur in a free enterprise capitalist economy.

Its importance lies in the fiscal policy to be pursued by the Government to get out of the depression and achieve the full state of employment and also in the foreign trade policies.

In relation to Two Sector ModelThe role of Multiplier Effect in two sector

model is limited to :a) Assessment of the overall possible increase

in the National Income due to “one-shot”increase in investment or due to a “single injection” investment.

b) To explain the Economic Growth of the country.

The Multiplier Equation DerivationWe know the value of national output equals aggregate

spending. Thus we have, Y = C+ILet us now suppose that investment increases by ΔI. This will

result in an increase in aggregate consumption expenditure and real national income.

Hence, any change in income Y is always equal to (ΔY) = ΔC + ΔI

Dividing both sides by Δy, we get : 1 = ΔC / ΔY + ΔI / ΔY

1 - ΔC / ΔY = ΔI / ΔY

since ΔC / Δy is the MPC and ΔI / Δy is reverse of multiplier.

We have 1/ multiplier = 1- MPCWhich yields the following result :

multiplier = 1 / 1- MPC.

How Does Multiplier Process WorkSuppose an economy is in equilibrium and

autonomous business investment increases by Rs 100 million .

Due to this effect the total output increases by Rs 100 million. Further it also means an additional income of Rs 100million has been generated in the form of wages,interest and profits.This makes the first round of income generation.

Assuming MPC =0.8;total expenditure on consumer goods=(100million ) X (0.8)=Rs 80million

This expenditure generates income worth Rs 8omillion in second round.

Working of Multiplier ProcessRound Income generation

Consumer spending Income generation

Ist round Nil 100.00

II nd round 80.00 80.00

III nd round 64.00 64.00

IV th round 51.20 51.20

V th round 40.96 40.96

---- ----

Last round 0

Total income 500.00

Value of multiplier is determined by MCPMCP M=1/(1-MPC) Multiplier(M)

0.00 M=1/(1-0.00) 1.00

0.10 M=1/(1-0.10) 1.11

0.50 M=1/(1-0.50) 2.00

0.75 M=1/(1-0.75) 4.00

0.85 M=1/(1-0.85) 6.67

0.90 M=1/(1-0.9) 10.00

1.00 M=1/(1-1) infinity

The process ends when aggregate production equals aggregate expenditures.

Static MultiplierStatic Multiplier is also known by names viz. ‘comparative static multiplier’ , ‘simultaneous multiplier’ , ‘logical multiplier’ , ‘timeless multiplier’ , ‘lagless multiplier’ .

It implies that change in investment causes in income instantaneously. It means that there is no time lag between the change in investment and change in income.

The moment a Rupee is spent on investment project, society’s income increases by a multiple of Re 1.

K=1/1-MPC

Dynamic MultiplierThe change in the income as a result of change in

investment is not instantaneous. There is a gradual process by which income changes as a result of change in investment.The process of change in income involves a time-lag.

Since Multiplier process works through the process of income generation and consumption ,the time lag involved is the gap between the change in income and the change in consumption at different stages.

The Dynamic Multiplier is essentially stage by stage computation of the change in income resulting from the change in investment till the full effect of the multiplier is realised.

Limitations 1. Payment of Past Debts2. Purchase of Existing Wealth3. Import of goods and services4. Non-availability of consumer goods and

services5. Full employment situation