Concept of Multiplier and Accelerator

The multiplier refers to the phenomenon whereby a change in an injection of expenditure (investment,
government expenditure or exports) will lead to a proportionately larger change (or multiple change) in
the level of national income i.e. the eventual change in national income will be some multiple of the
initial change in spending.

The multiplier effect comes about because injections of new demand for goods and services into the
circular flow of income stimulate further rounds of spending because “one person’s spending is
another’s income”. This leads to a bigger final effect on the level of national output and also total
employment in the labour market.

We need to understand that a multiplier refers to an economic factor that when increased or changed
causes increase or changes in many other related economic variables. Let's look at what may happen
if there was an injection of extra money into government provided health care in an economy.
Certainly, some of the money will go to doctors and nurses in the form of a salary increase or to
employ new doctors and nurses, but new building and equipment will probably also be bought. This
will boost sales of those making such items and so allow them to consume more. This 'first round
effect' is the big boost to spending within the economy. Now, what the doctors and nurses will do with
their salary hike? Just like the rest of us and they too will spend some of their salary increase and so
they will buy more and because of this the producers of the goods and services will have to employ
more labour and these people will spend part of their salary and so it goes on. The amount that is
passed on will diminish in each successive round of spending but the overall injection into the
economy will be greater than the first sum that was put into it.

The size of the multiplier can be worked out by dividing the increase in national income that
eventually occurs by the increase in injections that caused it.

Multiplier = change in GDP / change in injections

The key determinants of the value of the multiplier are:

 The size of the savings ratio - the more people save of any increase in income, the less the
increase in spending at each stage of the process.
 The amount spent on imports - if a lot of the extra spending created goes on imported
goods and services, then this money will be lost out of the country and not passed on within
the economy.
 The level of taxation - any increase in income will also mean higher tax revenue. However, if
the government use this extra revenue to spend on public sector investment and employment,
then this may help the process continue.

In a nutshell If I say when the government spends money it becomes somebody’s income and they
save a portion of that and they spend a portion of that. this keeps happening over and over again and
that’s called the multiplier effect. We often use two words with multiplier effect

1. Marginal Propensity to Consume (MPC)

2. Marginal Propensity to Save (MPS)

Marginal propensity to consume and Marginal Propensity to save

The size of the multiplier depend upon how much people spend or save when they get a new income,
that is called the marginal propensity to consume and marginal propensity to save

The marginal propensity to consume is the proportion of each extra pound of income spent by
households. For example, if a person earns £1 more and consumes 70p of it, then the MPC is 0.7.

The value of the multiplier can be calculated from the following formula:

Multiplier = 1 / 1 - MPC = 1 / MPS

Where MPC is marginal propensity to consume and MPS is marginal propensity to save.

Accelerator

The multiplier and the accelerator are not rivals they are parallel concepts while
multiplier shows the effect of changes in investment or changes in income ( and
employment),the accelerator shows the effect of change in consumption on private
investment or it is the link between the consumption and investment.

Consider an Industry where demand is rising ( for example telecommunication industry)

initially by using their existing quickly. Firms may respond initially by using their existing
productive capacity more intensively or running down stocks of finished products if they
expect high demand will be sustained -they m ay increase spending on plants and
machinery ,factories and new technologies in order to increase their supply capacity.
This causes an accelerator effect where a given change in demand for consumer goods
and services will cause a bigger percentage change in demand for capital goods.

We know how economies tend to grow in cycles - we called this the trade cycle or business cycle.
One of the major factors contributing to this cycle is the instability of investment. When the economy is
doing well, firms will invest to provide the extra capacity they need for increased production. However,
when growth starts to slip, firms will tend to stop investing - in fact investment may become negative.
Why invest if there is no need for extra capacity and you cannot even sell what you are currently
making! The changes in investment during the different phases of the trade cycle may therefore be
several times that of the rise or fall in income.

So we can see that investment depends not so much on the level of income and consumer demand,
but on their rate of change. Firms are investing to provide production capacity and so they will invest
according to how much demand is growing, not according to the actual level of demand. This link
between investment and the rate of change of demand is called the accelerator theory. Fluctuations
in investment will be much greater than those in income, but because investment is an injection into
the circular flow of income they will have a multiplied effect and this will magnify the ups and downs of
the trade cycle.
The accelerator principle states that changes in the level of current income, leading to changes in
output of consumer goods, will lead to proportionately greater, or accelerated changes, in the output
of capital goods, i.e. investment

The accelerator principle indicates how changes in the level of current income will have an
accelerated impact on the level of investment and is therefore one explanation of economic instability
and the upward and downward swings of the trade cycle.

Thus the multiplier and accelerator principle enables us to understand the process of income
generation.