Concept of Multiplier - Economics

John Maynard Keynes, 1919 and 1945

THE AGGREGATE DEMAND IS
COMPOSED OF :

1. CONSUMPTION DEMAND
2. INVESTMENT DEMAND

FROM THE CONCEPT OF MULTIPLIER IT

IS KNOWN HOW MUCH OR HOW
MANY TIMES INCOME INCREASES AS
INVESTMENT IS DONE.
AS INVESTMENT INCREASES
NATIONAL INCOME INCREASES
PROPORTIONATELY MUCH MORE.

HOW MANY TIMES IT INCREASES

DEPENDS ON MPC.

HIGHER THE MPC THE NATIONAL

INCOME WILL BE GREATER DUE TO
INVESTMENT.
RATIO OF CHANGE IN CONSUMPTION
TO CHANGE IN INCOME INDICATE
THAT PART OF ADDITIONAL INCOME
WHICH IS NOT SPENT ON
CONSUMPTION.
EG. NATIONAL INCOME = 1200CR
FROM 1000CR
CONSUMPTION EXPENDITURE =
900CR FROM 800CR
MPC = 100/200 =.5
THAT PART OF INCOME WHICH IS USED
FOR FURTHER PRODUCTION
EXPENDITURE MADE FOR THE
CREATION OF NEW CAPITAL ASSETS
LIKE MACHINE, TOOLS, BUILDING ETC.

TYPES OF INVESTMENT –

AUTONOMOUS INVESTMENT
PRIVATE OR PUBLIC INVESTMENT
INDUCED INVESTMENT
The Keynesian system:
Planned and actual
investment
Investment has three components:
• Plant and equipment -- drill presses,
factory buildings, etc.
• Residential investment -- new
housing construction
• Inventory investment -- Change in
Business Inventories
The Consumption Function: the key to Keynes

Consumption depends on the level of DISPOSABLE

INCOME (disposable personal income = income -
taxes = Y - T)
Some consumption is autonomous (= “independent” of
DPI): it may depend on other factors such as
wealth or stock values. (even at zero income, Bill
Gates would consume something)
The consumption function proposed by Keynes is:

C = C 0 + C y ( Y - T)

C0 = A utono mo us c on sum ptio n

Cy = Margi na l p rop ens ity t o co ns ume

The marginal propensity to consume plays a

central role in the Keynesian system. Keep your eye on
the MPC in the following slides.
THERE IS AUTONOMOUS INVESTMENT IN ECONOMY
MARGINAL PROPENSITY TO CONSUME REMAINS
CONSTANT
CONSUMPTION IS THE FUNCTION OF CURRENT
INCOME
NO TIME LAG BETWEEN RECIEPT OF INCOME AND ITS
DISPOSAL IN FORM OF CONSUMPTION
NET INCREASE IN INVESTMENT
SUPPLY OF CONSUMER GOODS IS ALWAYS IN
ECONOMY
IT IS ASSOCIATED WITH CHANGE IN
INVESTMENT
SIZE OF MULTIPLIER DEPENDS UPON
SIZE OF MPC
MULTIPLIER WORKS IN BOTH FORWARD
AND BACKWARD DIRECTION
VALUE OF MULTIPLIER VARIES FROM
UNITY TO INFINITY
 HIGHER THE MPC –LARGER THE
MULTIPLIER SIZE
LARGEST POSSIBLE MPC IS UNITY
IF MPC IS ZERO MULTIPLIER IS UNITY
K=1/1-MPC THAT IS RECIPROCAL OF
MARGINAL PROPENSITY TO SAVE
TOOL OF ANALYSYING GROWTH,
PLANNING, PROJECTING,
INVESTMENT REQUIREMENT
TOOL FOR ACHIEVING TARGETED
GROWTH RATE, IF MPC IS GIVEN
TOOL FOR ANALYSING THE
FLUCTUATIONS IN THE ECONOMY
IMPORTANT TOOL FOR ANALYSING
IMPACT OF TAXATION, FOREIGN
TRADE ON THE ECONOMY
MULTIPLIER DEPENDS ON A LARGE
NUMBER OF FACTORS ALONG WITH MPC
EFFICIENCY OF PRODUCTION
REGULAR INVESTMENT
MULTIPLIER PERIOD
FULL EMPLOYMENT CEILING
ASSUMPTION THAT GOODS AND SERVICES
ARE AVAILABLE IN ADEQUATE SUPPLY
GOODS AND SERVICES CANNOT BE
PRODUCED IN EXCESS OF THEIR FULL
EMPLOYMENT LEVEL
USEFUL TO ANALYZE PUBLIC
INVESTMENT
REMOVES DEPRESSION THROUGH
GOVERNMENT INVESTMENT
ACHIEVING FULL EMPLOYMENT
MARGINAL EFFICIENCY OF CAPITAL
EMPLOYMENT RISES
PRIVATE INVESTMENT ENCOURAGED
STATIC MULTIPLIER
COMPARATIVE STATIC MULTIPLIER
DYNAMIC MULTIPLIER
PROPOUNDED BY KAHN
GOVERNMENT UNDERTAKES PUBLIC
WORKS,THIS LEADS TO INITIAL AND
PRIMARY EMPLOYMENT.
THIS RESULTS IN INCREASE IN DEMAND
FOR CONSUMPTION GOODS WHICH IN
TURN PROVIDES MORE EMPLOYMENT.
 Does not applies to
underdeveloped countries like
India.
REASONS:
1.DEMANDS CAN BE MET EASILY IN
DEVELOPED COUNTRIES.
2.SUPPLY OF RAW MATERIALS IS ELASTIC
IN DEVELOPED COUNTRIES.
3.THERE IS NO INVOLUNTARY
PAYING OF DEBTS
IDLE CASH BALANCES.
IMPORTS.
PURCHASE OF EXISTING SECURITIES.
PRICE INFLATION
Keynesian equilbrium: Solution procedure
Start with the equation in general form:

Y = C0 + Cy ( Y - T) + Ip + G + NX
Substitute in the given numbers:
Y = 300 + 0.8 ( Y - 1000) + 1500 + 1200 + 500
Collect all the constant terms:
Y = 3500 + 0.8Y - 800
Y = 2700 + 0.8Y
Subtract 0.8 Y from both sides of the equation:

0.2 Y = 2700
Finally, multiply both sides by 1 / 0.2 = 5

Y = 5 (2700) = 13, 500

The Multiplier
Rerun the previous exercise, raising planned investment by 500.
Y = 300 + 0.8 ( Y - 1000) + 2000 + 1200 + 500
Collect all the constant terms:
Y = 4000 + 0.8Y - 800
Y = 3200 + 0.8Y
Subtract 0.8 Y from both sides of the equation:

0.2 Y = 3200
Finally, multiply both sides by 1 / 0.2 = 5
Y = 5 (3200) = 16, 000
GDP is UP BY 2,500, NOT up by only 500.
Investment spending has a MULTIPLIER EFFECT of 5