Multiplier Concepts & EffectsBy Atindya K Ghosh

Objectives

Understand the multiplier concept.Utilise the multiplier formula.Explain the multiplier determinants.Analyse the interaction of the multiplier,

accelerator and economic cycle.Evaluate the significance of marginal

propensity to Save, Tax and Import.

Introduction

In economics or macroeconomics, a multiplier is a factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable.

For example, suppose variable x changes by 1 unit, which causes another variable y to change by M units. Then the multiplier is M.

The Multiplier effect

Process by which any change in a component of AD results in greater final change in real GDP.

The size of the multiplier is determined by the size of the leakages from the circular flow of income.

Factorpayments

Consumption ofdomestically

produced goodsand services (Cd)

The circular flow of incomeThe circular flow of income

Firms

Households

Factorpayments

Consumption ofdomestically

produced goodsand services (Cd)

Investment (I)

Governmentexpenditure (G)

Exportexpenditure (X)

BANKS, etc

Netsaving (S)

GOV.

Nettaxes (T)

ABROAD

Importexpenditure (M)

LEAKAGES

INJECTIONS

The circular flow of incomeThe circular flow of income

Let’s assume Government increases spending on education, raising wages of teachers by `5 Cr. i.e. Injection.

Teachers spend this money, which in turn becomes income for other people.

The proportion of income that goes towards leakages is the Marginal Propensity to Withdraw [MPW].

Let’s assume half the injection goes towards savings, tax or imports. That means the MPW is 0.5. Then the question arise, “What happens to the actual GDP?”

The Multiplier effect

Total Income of A

This square represents the initial increase in income of `5Cr by the Teachers or “A”

If marginal propensity to withdraw is 0.5; half is spent (MPC 0.5)

Total Income left for A

Total Expense for A or Total Income for B

Total Income of A

The amount spent by “A” is income for other people or “B”

Total Income of B

Total income so far by “A” & “B”

Total Income for both A & B

Half of the new income is spent by “B” to “C”

Total Income of AT

otal Ex pense

of B or T

otal Incom

e of C

Total Income left for B

Total income so far by “A”, “B” & “C”

Total Income of A

Total Income of C

Total Income of B

Half of the new income of “C” is spent and becomes income for other people i.e. “D”

Total Income of A

Total Income of B

Total Income left for C

Total Expense of C or Total

Income of D

Total income so far by “A”, “B”, “C” & “D”

Total Income of A

Total Income of C

Total Income of B

Total Income of

D

Eventually…

The initial `5Cr eventually becomes `10Cr through the multiplier effect. National income has been multiplied by factor of 2.

Formulas for Calculating MPW:MPW = MPS + MPT + MPMK = 1/[MPS + MRT + MPM] = 1/MPW

Accelerator

The theory of investment that states the level of investment depends on the rate of change of the national income.

Recession: Firms decreases its investment.

Boom: Firms increases its investment.

“Investment mainly depends on RATE OF CHANGE but not on its actual level.”

Interaction of Multiplier & Accelerator

This is a theoretical explanation of the Economic Cycle.

Economy growing leads to investment which leads to a multiplier effect which leads to further economic growth.

However, if economy in recession the effect works in the opposite direction.

Evaluating the Interaction of Multiplier & Accelerator Model

Economy might be growing, but a question always arise i.e. whether the business will be sustain or not?

Investment decisions are large and complex, made well before changes in the economic conditions.

Exogenous factors just as influential.

‘No more boom and bust’ – Governments can smooth out the economic cycle through fiscal and monetary policies.

However, investment is an important component of AD and firms do respond to consumer demands. The multiplier model is not the only force behind the economic cycle.

ConclusionEconomist Robert  Barro believes  that  the Keynesian 

multiplier is  close  to  zero.  For  every  dollar  the government borrows and spends, spending elsewhere in the economy falls by almost the same amount.

The modern theory of the multiplier was developed in the 1930s,  by Kahn, Keynes, Giblin,  and  others,  following earlier  work  in  the  1890s  by  the  Australian  economist Alfred De Lissa, the Danish economist Julius Wulff, and the German-American economist N. A. J. L. Johannsen.

Thank You