Theory of Multiplier

Total increase in income is much larger than the original increase in investment because one mans income expenditure is other mans income K= Y I K= Multiplier Y= Incremental income

 I= Incremental investment Y = I I I-MPC MPC= Marginal propensity to consume K= I MPS MPS = Marginal propensity to save.

Multiplier : A numerical example

Round of spending Initial increase 2 3 4 Increase in Cumulative Total spending (Rs.cr.) 100.0 100 80.0 64.0 51.2 180 244 295.2

5
6 7

41.0
32.8 26.2

336.2
369.0 395.2

8
9 10

21.0
16.8 13.4

416.2
433.0 446.4

11 to 20 combined All others

47.9 5.7

494.3 500

(Assuming MPS= 80% or 0.8%)

 Investment multiplier= increase in GDP that would result from a Rs. I increase in expenditure (say on investment by Govt) Ripple effect Multiplier= I I-MPC I C S 100 65 35 65 42.25 22.75 42.25

 100x I I-0.65

= Rs.285.71

Assumptions
1. MPC remains constant 2. There is no time lag between the investment and the resultant increase in income. 3. Presence of excess capacity in consumer goods industries. 4. Keynesian multiplier does not fully work in developing economies like India due to lack of excess capacity in wage goods industries.

Inferences of the principle of investment multiplier

1. Govt. investment financed by borrowing (and not taxation) could boost aggregate demand by a higher amount than initial spending 2. An increase in MPC will result in an increase in the value of multiplier. 3. If investment is financed by tax, the multiplier would be equal to I. It is called Balanced Budget Multiplier. 4. It is assumed that household, do not hoard money.

Leakage in the multiplier process

1. Saving is a leakage. Therefore multiplier is less than infinity. 2. Paying off debts 3. Holding of idle cash 4. Imports 5. Taxation-Can be offset through increase in public expenditure 6. Impact of inflation/ deflation can cause a gap between working of multiplier in money terms and in real terms.

 Foreign Trade Multiplier is the ratio of resulting increase in gross domestic product (GDP) to an addition to net exports (ExportsImports) Trade adjusted multiplier would be smaller or bigger depending on the role external sector (net exports) play in the economy. Higher the export demand, higher would be foreign trade multiplier and vice versa.

Simple Keynesian Multiplier Model

Spend more, employ more Run Government deficits at less than full employment to boost employment Run Foreign Trade Surpluses Raise the propensity to consume Is growth promoted by equality or inequality?

 How do we alter propensity to consume? Social safety net Wealth effect

Limitations of the Multiplier

1. Leakages from the income stream: 2. Availability of consumer goods: 3. Time lags: 4. Full employment ceiling: 5. Effect of induced consumption on investment:

Multiplier and Underdeveloped Economies

1. Involuntary unemployment: 2. Elastic supply: 3. Excess capacity in consumer goods industries: 4. Elastic supply of capital:

 My conclusion, therefore, is that multiplier principle as enunciated by Keynes does not operate in regard to the problem of diminishing unemployment and increasing output in an underdeveloped economy, an increment of investment based on deficit financing tending to lead more to an inflationary rise in prices than to an increase in output and employment. V.K.R.V Rao