Multiplier Analysis

Definition of MultiplierIt is the ratio of the change in national Income due to change in investment.

Understanding the definitionIn economics, the multiplier effect refers to the idea that an initial spending rise can lead to even greater increase in national income. In other words, an initial change in aggregate demand can cause a further change in aggregate output for the economy.Investment multiplier is simply the multiplier effect of an injection of investment into an economy. In general, a multiplier shows how a sum injected into an economy travels and generates more output.

Multiplier It must be noted that the extent of the multiplier effect is dependent upon the marginal propensity to consume . Also that the multiplier can work in reverse as well, so an initial fall in spending can trigger further falls in aggregate output.

Preliminary termsConsumption function: It is a mathematical expression of the relationship between aggregate consumption expenditure (C) and aggregate disposable income (Y) expressed as C= f(Y). C accounts for the largest proportion of the aggregate demand in an economy and plays a crucial role in the determination of NI.

Consumption function C = a + bYC= Aggregate consumption expenditureY= total disposable Income a = autonomous consumption. This is the level of consumption that would take place even if income was zero. If an individual's income fell to zero some of his existing spending could be sustained by using savings.

Consumption functionb =marginal propensity to consume (mpc). This is the change in consumption divided by the change in income. Simply, it is the percentage of each additional rupee earned that will be spent.Mpc = C/ Y= b

Other Factors affecting consumption functionIncome is not the only factor influencing consumption. C=f(Y, OF)where: C is consumption expenditures, Y is income (national or disposable), and now OF is specified as other factors affecting consumption. These other factors, officially referred to as consumption expenditures determinants, include a range of influences.

Some of the more notable consumption determinants are consumer confidence, interest rates, and wealth.Consumer confidence is the general optimism or pessimism the household sector has about the state of the economy. More optimism means more consumption.

Interest rates affect the cost of borrowing the funds used to purchase durable goods. Higher interest rates mean less consumption. Wealth is the financial and physical assets owned by the household sector. More financial wealth means more consumption, while more physical assets mean less consumption.These determinants cause consumption expenditures to change even though income does not change

Savings FunctionIncome that consumers earn but do not spend on consumption will be saved in some form. Y = C + S If the consumption function is C = a + bYdThen the savings function is given by: S = -a + (1-b) YdWith zero income consumers still spend the amount "a"; this means they dissave "a".Out of each 1 consumers spend "b"; this means they save (1-b). e.g. if the marginal propensity to consume is 0.8 then the marginal propensity to save is 0.2

Investment MultiplierMultiplier (m) = Y/I = 1/ 1-bThis relationship can be arrived at by understanding the shift in the aggregate demand function.As the demand curve shifts upward due to additional investment I, the real income of the economy also increases by Y

Assumptions of 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 exists 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. (graphical explanation)

Importance of Multiplier effectTo 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 a Two Sector ModelThe role of Multiplier Effect in two sector model is limited to : Assessment of the overall possible increase in the National Income due to one-shotincrease in investment or due to a single injection investment 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+I Let us now suppose that investment increases by I. This will result in an increase in aggregate consumption expenditure and real national income. Hence, any change in income Y is always equal to (Y) = C + I . By substituting the values of C, we get the final output as multiplier = 1 / 1- MPC.

Working of Multiplier processSuppose an economy is in equilibrium and autonomous business investment increases by Rs 100 million . Due to this effect the total output increases by Rs 100million. 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 80million in second round.

Working of Multiplier process

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, societys 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.

Dynamic MultiplierSince 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.

Limitations1 ) Rate of multiplier dependent on rate of MPC i.e. lower MPC rate implies lower rate of multiplier and vice versa. This may not be a practical situation for developing and underdeveloped countries.2) The process assumes no leakages in the consumption out of new income which is not practical since part of the additional income may be spent on:

Limitations Contd..Payment of Past DebtsPurchase of Existing Wealth Import of goods and services etc.This means no new demand for consumer goods is generated here.3. Non-availability of consumer goods and services in line with the actual demand.4. Full employment situation means no additional real income. +++++++++++++++