Introduction

• Closely connected to the ‘Marginal Propensity to Consume’.

• Keynes’ path breaking contribution to economic analysis.

• Popularly called Keynes’ “Investment Multiplier”.

Meaning of Multiplier

• Relationship between initial increment in investment & final increment in aggregate income.

• Definition: Ratio of change in income to the change in investment.

• Shows the number of times an initial change in investment leads to multiple changes in consumption and ultimately aggregate income.

Reasoning of the Multiplier

• Investment leads to increase in aggregate income by something more than the amount of the original investment.

• Original investment increases income in concerned industries and also in other industries of products demanded by the investment industries employees.

Size of the Multiplier

• Dependant on size of the marginal propensity to consume.

• Higher the MPC, higher the multiplier’s size and vice versa.

• Size of the multiplier derived from the MPC.

Measure of the Multiplier

• Equal to the reciprocal of 1 minus the MPC.

• K = 1 / 1 – MPC (or) 1 / MPS since MPC + MPS = 1.

Explanation

• MPC = 0, K = 1 i.e. nothing is spent by the consumers out of increased incomes.

• If MPC = 1, then MPS = 0 and K = ∞ i.e. consumers spend the whole of the increment of income on consumption and nothing is saved.

• Both are rare cases.

Summing Up

The size of the multiplier varies directly with the size of the marginalpropensity to consume. When the marginal propensity

to consume is high the multiplier is high, and when the marginal propensity to consume is low it is low.

Some Observations

• Increase in investment has secondary consequences.

• Result: increase in income larger than initial increase in investment.

• Such a multiple increase in spending not an easy process.

• The MPC depends on consumers’ reaction which is difficult to predict.

Assumptions or Limitations of the Multiplier

• Multiplier works fully if the assumptions operate completely.

• Working of multiplier slows down by non – fulfillment or partial fulfillment of the assumptions.

Availability of Consumer Goods

• Consumption goods to be available in adequate quantity.

• Income recipients not have much to spend on in case of scarcity of consumption goods.

Maintenance of Investment

• Various increments in income to be repeated at regular intervals.

• Break in continuity of investment will push national income back to the original level.

Net Increase in Investment

• Additional investment in one sector not to be offset by disinvestment in some other sector of the economy.

• Ex: increase in public investment being neutralized by a fall in private investment.

• Means no net increase in investment diminishing the effect of the multiplier.

No Investment From Induced Consumption

• No effects of induced consumption on investment.

• Investment to increase only by the original amount.

• Induced investment on consumption increases value of multiplier beyond expected levels.

Existence of Closed Economy

• No trade relations with the outside world.

• In open economy value of multiplier either more or less than its real value.

No Time Lags between Successive Expenditure on Consumption

• No time interval between receipt of income and spending it.

• Longer the time lags fewer the secondary consumption expenditure and smaller the value of the multiplier.

Existence of Less than Full Employment

• Existence of involuntary unemployment.

• Chances for income, output and employment continuing to expand due to operation of the multiplier.

• At full employment stage income, output and employment stops increasing irrespective of the size of the marginal propensity to consume.

Conditions for operation of The Multiplier

1. Existence of Involuntary Unemployment.

2. Existence of an Industrialized Economy.

3. Existence of Excess Capacity in consumer goods industries.

4. Existence of Elastic Supply of Capital.

Leakages and the Multiplier

• MPC rarely equal to 1 or 100%.

• Due to several leakages from the income stream.

Savings

• Means people do not spend entire, increment in income on consumer goods.

• Saved portion of the increased income limits value of the multiplier.

• Higher the propensity to save, lower shall be the value of the multiplier.

Other Leakages

• Debt Cancellation: part of the new increment in income used to pay off debts.

• Accumulation of Idle Case Deposits: saved as idle bank deposits.

• Purchase of old stocks and securities: failure to spend on consumption.

• price inflation: dissipates the potential of higher income to increase consumption, income and employment.

• Taxes & Corporate savings: brings down propensity to consumer by reducing purchasing power through non – availability of income with corporations and people.

Expenditure on Imports

• Does not add to domestic income and employment.

• Has no effect on consumption of domestic goods.

• An important leakages from the domestic income stream.

Reverse Working of the Multiplier

• Multiplier may work in the backward or reverse direction.

• Reduction in investment leads to reverse operation of the multiplier.

• Net reduction in investment first adversely affects people engaged in investment industries.

Reverse Multiplier

Higher the value of the multiplier greater shall be the reduction in aggregate income. If MPC = 1, then the reverse working of the multiplier would result in a complete collapse of economic activity. As normally

MPC < 1 or K ≠ ∞ the effect of ‘Reverse Multiplier’ is relatively less.

Criticism of Multiplier

1. No precise, predeterminable or mechanical relationship between investment and income.

2. Multiplier concept creates problem of inequality between saving and investment because it assumes that what is not spent on consumption is not spent on anything at all as it is only hoarded.

3. Multiplier concept does not go along with Keynes’ definition of ‘savings’ and ‘investment’ as given by him in the ‘The General Theory’.

4. Is one – sided as it does not account for ‘induced investment’ i.e. effect of increase in consumption on investment.

• A theoretical concept.

• An important instrument of economic policies.

• Has focused attention on investment as a major dynamic economic element for a country.

• Strengthened the case for public investment especially during depression and unemployment.

• Helped the government to formulate appropriate employment policy during depression.

• Helpful to trace the course the business cycle and also to develop anti – cyclical policies so as to smoothen business fluctuations, in the working of the economy.