The Concept….. The concept of multiplier was first developed byF.A.Kahn in the early 1930s. The concept was laterrefined by Keynes. F.A.Kahn developed the concept of multiplier withreference to the increase in employment,direct as wellas indirect,as a result of initial increase in investmentand employment. Later on Keynes propounded the concept of multiplierwith reference to the increase in total income,direct aswell as indirect,as a result of original increase ininvestment and income.
Cont….. Kahn’s Multiplier is known as “EmploymentMultiplier” and Keynes multiplier is known as“Investment or Income multiplier”. The Value of Multiplier ork = 1/1-MPC
Assumptions for Multiplier Effect The marginal propensity to consume remains constantthroughout as the income increases. There is a net increase in investment over thepreceding year. There is no any “time-lag”between the increase ininvestment and the resultant increment in income. Excess capacity exsists in the consumer goodindustries.
Shift in Aggregate Demand andMultiplier In the two-sector model, a change in aggregatedemand is caused by a change in consumptionexpenditure or in business investment or in both. Consumption expenditure is however more stablefunction of income. A change is assumed in the aggregate demandfunction due to a change in the business investment.
Importance of Multiplier To explain the cumulative upward and downwardswings of trade cycles that occur in a free enterprisecapitalist economy. Its importance lies in the fiscal policy to be pursued bythe Government to get out of the depression andachieve the full state of employment and also in theforeign trade policies.
In relation to Two Sector Model The role of Multiplier Effect in two sector model islimited to :a) Assessment of the overall possible increase in theNational Income due to “one-shot”increase ininvestment or due to a “single injection” investment.b) 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+ILet us now suppose that investment increases by ΔI. This will resultin an increase in aggregate consumption expenditure and realnational income.Hence, any change in income Y is always equal to (ΔY) = ΔC + ΔIDividing both sides by Δy, we get :1 = ΔC / ΔY + ΔI / ΔY1 - ΔC / ΔY = ΔI / ΔYsince ΔC / Δy is the MPC and ΔI / Δy is reverse of multiplier.We have 1/ multiplier = 1- MPCWhich yields the following result :multiplier = 1 / 1- MPC.
How Does Multiplier Process Work Suppose an economy is in equilibrium and autonomousbusiness 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 Rs100million has been generated in the form of wages,interestand profits.This makes the first round of incomegeneration. Assuming MPC =0.8;total expenditure on consumergoods=(100million ) X (0.8)=Rs 80million This expenditure generates income worth Rs 8omillion insecond round.
Working of Multiplier ProcessRound IncomegenerationConsumer spending Income generationIst round Nil 100.00II nd round 80.00 80.00III nd round 64.00 64.00IV th round 51.20 51.20V th round 40.96 40.96---- ----Last round 0Total income 500.00
Value of multiplier is determined byMCPMCP M=1/(1-MPC) Multiplier(M)0.00 M=1/(1-0.00) 1.000.10 M=1/(1-0.10) 1.110.50 M=1/(1-0.50) 2.000.75 M=1/(1-0.75) 4.000.85 M=1/(1-0.85) 6.670.90 M=1/(1-0.9) 10.001.00 M=1/(1-1) infinityThe process ends when aggregate production equalsaggregate expenditures.
Static Multiplier Static Multiplier is also known by names viz.‘comparative static multiplier’ , ‘simultaneousmultiplier’ , ‘logical multiplier’ , ‘timeless multiplier’ ,‘lagless multiplier’ . It implies that change in investment causes in incomeinstantaneously. It means that there is no time lagbetween the change in investment and change inincome. The moment a Rupee is spent on investment project,society’s income increases by a multiple of Re 1. K=1/1-MPC
Dynamic Multiplier The change in the income as a result of change ininvestment is not instantaneous. There is a gradual processby which income changes as a result of change ininvestment.The process of change in income involves atime-lag. Since Multiplier process works through the process ofincome generation and consumption ,the time lag involvedis the gap between the change in income and the change inconsumption at different stages. The Dynamic Multiplier is essentially stage by stagecomputation of the change in income resulting from thechange in investment till the full effect of the multiplier isrealised.
Limitations1. Payment of Past Debts2. Purchase of Existing Wealth3. Import of goods and services4. Non-availability of consumer goods and services5. Full employment situation