Definition of Multiplier
It is the ratio of the change in
national Income due to
change in investment.
Understanding the definition
• In 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.
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.
Consumption function: It is a mathematical
expression of the relationship between
aggregate consumption expenditure (C) and
aggregate disposable income (Y) expressed as
C accounts for the largest proportion of the
aggregate demand in an economy and plays a
crucial role in the determination of NI.
C = a + bY
C= Aggregate consumption expenditure
Y= 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.
b =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
Mpc = ∆C/ ∆Y= b
• Multiplier (m) = ∆Y/∆I = 1/ 1-b
This relationship can be arrived at by
understanding the shift in the aggregate
As the demand curve shifts upward due to
additional investment ∆I, the real income of
the economy also increases by ∆Y
Assumptions of Multiplier Effect
• The marginal propensity to consume remains
constant throughout as the income increases.
• There is a net increase in investment over the
• There is no any “time-lag” between the increase in
investment and the resultant increment in income.
• Excess capacity exists in the consumer good
Shift in Aggregate demand and
• In 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 effect
• To 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
In a Two Sector Model
The 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
The Multiplier Equation derivation
We know the value of national output equals aggregate
spending. Thus we have, Y = C+I
Let 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 . By substituting the values of C, we get
the final output as
multiplier = 1 / 1- MPC.
Working of Multiplier process
• Suppose 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
• Static 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
• 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.
The 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.
1 ) 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
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 Debts
• Purchase 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.