Multiplier PDF

Multiplier Dr. A. K. Dash IBS Hyderabad, IFHE University  Multiplier The concept of multiplier was first developed by RF Khan in 1931. He developed the employment multiplier. He traced the effects of an increase in investment on employment. Keynes investment multi...

Multiplier Dr. A. K. Dash IBS Hyderabad, IFHE University  Multiplier The concept of multiplier was first developed by RF Khan in 1931. He developed the employment multiplier. He traced the effects of an increase in investment on employment. Keynes investment multiplier is a modification of Khans employment multiplier which shows the relationship of a small increase in investment to final increase in income. The concept of multiplier occupies an important place in the Keynesian theory of income, employment and output. In consumption function MPC is less than 1 (or unity). Therefore, all the increase in income, do not increase the consumption at the same extent. As a result, a gap exists between income and consumption which must be made up by investment. Keynes believed that the initial increment in investment increases the final income by many times. The relationship between an initial increase in investment and final increase in income Keynes gave the name of “investment multiplier” also called income multiplier by others. Multiplier is the ratio of the final change in income to the initial change in investment. In other words, it is the ratio of expressing the quantitative relationship between the final increase in national income and increase in investment. Arithmetically, this relationship is expressed as K= Where Y is national income K is multiplier I is investment Hence investment multiplier K= If investment in the economy increases by 1 crore and national income rises by 3 crore, then the multiplier is 3. It implies each one rupee of investment generates 3 rupees of output. All this happens because whenever an investment is made in the economy, the effects is to increase total income notonly by the amount of original investment but by a multiple of it. The value of multiplier is in fact determined by the marginal propensity to consume. Higher the value of MPC, higher is the value of multiplier and vice versa K= , K= K is the multiplier and 1- is the marginal propensity to save. Multiplier Process with Tabular Representation Let’s assume your investment is 100 crore on building. In order to construct the building, you require labour, cement, bricks, land etc. When you are buying these others will get income (I mean your spending is others income). Let’s assume MPC is =0.5 Investmen Income Consumption Saving t 100 Crore 100 50 50 50 25 25 25 12.5 12.5 12.5 6.25 6.25 6.25 3.12 3.12 3.12 1.56 1.56 1.56 0.78 0.78 0.78 0.39 0.39 Let's assume that initial investment of an economy is 100 crore and MPC =0.5. Find out the final increase in income through multiplier process. You know that MPC+MPS=1 K= = 1/0.5= 2. Initial investment is 100 crore. Then final increase in income is 100*2=200 crore  Assumptions of Multiplier  There is a change in autonomous investment and induced investment is absent  There is less than full employment level in the economy  There is no changes in prices and wages  There is a closed economy unaffected by foreign influences  There is an industrialized economy, in which multiplier process operates  The MPC is constant  Consumption is a function of current income  There is no time lags in the multiplier process. Any increase(decrease) in investment instantaneously lead to a multiple increase(decrease) in income. Investment Multiplier through Saving and Investment Approach Investment Multiplier through Saving and Investment Approach S is the saving curve. I is the investment curve. Both Saving and investment curve intersects with each other at point E0. So, OY0 level of income is generated. If there is increase in investment (I), the new investment curve is I+ I which intersect the saving curve at E1 and OY1 level of income is generated. Thus, the rise in income from Y0 to Y1 is more than the increase in investment of I. Keynes Investment Multiplier through Agg. Exp. Approach  Keynes Investment Multiplier through Agg. Exp. Approach continues The X axis represents income, output and the Y axis represent the aggregate expenditure(which is consumption expenditure, investment expenditure and government expenditure). We have not included net exports for simplicity. The 45 degree line represents income, Y. It is also known as aggregate supply curve.The aggregate demand curve is represented through C+I+G. It is not downward slopping because we are taking AD with respect to income. Both AD and AS curve intersect with each other at point E0 and the equilibrium level of income is OY0. Let’s assume that an autonomous investment(I) takes place which pushing up the aggregate demand curve to C+I+G+I. The new curve C+I+G+I intersects the aggregate supply curve (Y=C+S) at point E1 which, therefore, is the new point of equilibrium where AD and AS curve intersect with each other. The equilibrium level of income is now OY1. Thus, as a result of an increase in investment by I, the level of income rises from Y0 to Y1. As seen from the figure, the increase in income is greater than the increase in investment. Y=C+S Y=C+I Let’s assume that investment increases by will result in an increase in aggregate consumption expenditure and income. Hence, any change in income Dividing =+ 1=+ = 1- is the marginal propensity to consume and is the reverse of the multiplier. We have = 1-MPC Which yields the following result K== Greater the value of MPC, greater is the value of the multiplier and vice versa. Two extreme cases of multiplier. When MPC=0 and when MPC=1. When MPC=0, K=1 and when MPC=1, K is infinity. Thus, the value of multiplier lies between 1 to. If the multiplier value is 1, it means the whole increment of income is saved and nothing is spend because the MPC=0. On the other hand, if multiplier value is it implies that MPC is equal to one and the entire increment of income is spend on consumption and no savings. But these are rare phenomena. Therefore, the multiplier coefficient varies between 1 and infinite Since, MPC is always greater than zero and less than 1, 0 < MPC