Chapter 8

Multiplier and accelerator

Multiplier (investment / income multiplier)
 Change in autonomous investment will cause a greater change in national income
 National income increases multiple times due to change in investment
Example
 Initial investment = 100
 New investment = 600
 Change in investment =∆I= 600-100= 500
 Initial national income = 500
 New national income = 1500
 Change in national income =∆Y= 1500-500=1000
 Multiplier = kI =Change in national income / Change in investment = ∆Y / ∆I =1000/ 500=2
 Multiplier = KI(investment multiplier) =2
Assumptions
 Marginal propensity to consume should remain same
 Investment should be continuous
 There should be no change in prices of goods in spite of change in income (any change in good’s
prices can change consumption pattern)
 Full employment has not achieved because, If there is no spare capacity in the economy /
economy is operating at full employment, then increase in the government investment causes
inflation, which would lessen the ‘real’ effects of the investment
 Tax rate should remain same (any change in tax rate causes change in disposable income which
further affects the consumption pattern). So, a stable fiscal policy is needed for smooth process of
multiplier
 Closed economic model (no influence of international trade / imports or exports)
Mathematical representation
 ∆Y =k(∆I)
 K is a function which means dependent. Change in national income depends upon change in
investment
 The investment multiplier (kI) indicates a relationship between an initial increment of investment
and the resulting increase in aggregate income
 The numerical coefficient (K) in the function indicates the increase in income due to increase in
investment
Note
 We consider change in exogenous investment (autonomous investment) only because they are
deemed as basic necessities to individual, organizational, or national well-being, health, and
safety, and are done even when levels of disposable income for investment are zero / close to zero

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Explanation of concept (Multiplier in closed economic model in absence of government)
“Spending of one is income of other”
 Portion of national income which is consumed is called marginal propensity to consume
 Portion of national income which is saved is called marginal propensity to save
 Suppose , we have 1000 national income, and we have 50% marginal propensity to consume. It
means we consume 500 rupees and save 500 rupees. But in multiplier we will have a complete
chain / series of events, we will continue this process. So, total change in national income can be
as described as in following
 ∆Y = 1000 + 1000(50%) + 1000 (50%)2 + 1000(50%)3 +… / ∆Y = 1000 + 50 + 25 + 12+….
 ∆Y = 1000 {1 + (50%) + (50%)2 + (50%)3 + ⋯}
 ∆Y = 1000 ( 𝑎 / 1−𝑟 )
 ∆Y = 1000 ( 1 / 1−50% ) 50% = 0.5
 ∆Y = 1000 (1 / 1-0.5)
 ∆Y = 1000 (1/0.5)
 ∆Y = 1000 (2)
 ∆Y = 2000
 ∆Y = ∆I (𝑘)
 Therefore,
 𝑘 = 1 / 1−MPC
 MPC+ MPS = 1
 MPS = 1 – MPC
 K = 1 / MPS
Conclusion
 Value of multiplier and MPC are directly proportion
Graphical representation

 The graph shows that MPC is assumed to be 0.5 and initial change in investment of Rs. 1,000.
The investment of Rs. 1,000 will lead to an in GNP (national income) by Rs.2,000
 Therefore, each Rs.1 of investment has been “multiplied” 2 times
Types of multiplier
 Positive multiplier
 Negative multiplier

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Positive multiplier
 Greater increase in national income due to a small increase in investment
Negative multiplier
 Greater decrease in national income from a tiny decrease in investment
Limitations
 Full employment State of multiplier works until the economy is operating less than the full
employment. Once full employment is achieved, process of multiplier becomes ineffective
 Availability of consumer goods Operation of multiplier works only if consumer goods are
available in surplus. If sufficient amount of consumer goods is not available, consumers will not
be able to spend their income along any increase in their income
 Time lags Time lag states a delay between an economic action and consequence. The second
limitation with the effectiveness of the multiplier effect is that a time lag exists between when the
initial investment will be made, and when the full effects of the multiplier will be felt
Multiplier extension (Multiplier in closed economic model in presence of government)
Marginal propensity to tax (MPT)
 Percentage of income that is paid to the government in the form of tax
Mathematical representation
 kt= 1 / MPS+MPT
Example
 Suppose people are saving 30% of their income voluntarily and paying 20% as tax to the
government then the tax multiplier will be
 𝐾𝑡 = 1 / 0.3+ 0.2
 𝐾𝑡 = 2
Multiplier in open economic model (with the effect of imports / exports)
Marginal Propensity to Import (MPM)
 Percentage of income that is used to buy goods and services from foreign economy
Mathematical representation
 𝐾𝑚 = 1 / MPS + MPT + MPM
Example
 Suppose people are saving 30% of their income voluntarily and paying 20% as tax to the
government. In addition, people are also spending 10% of their income on imports, then the value
of multiplier will be
 𝐾𝑚 = 1 / 0.3 +0.2+ 0.1
 𝐾𝑚 = 1 / 0.6 = 1.67
Accelerator
 Change in income accelerates the change in the induced investment
 Change in level of income causes greater change in investment (capital good)
 Change in demand of consumer goods causes greater change in demand of capital goods
Mathematical representation
 I = 𝑓 (Y)
 ΔI = β (𝛥Y)
 β = ΔI ΔY
 β is a function which means dependent. Change in investment depends upon change in income

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  The accelerator indicates a relationship between an initial increment in income and the resulting
increase in investment
 The numerical coefficient (β) in the function indicates the increase in investment due to increase
in income
Assumptions
 Constant Capital (investment)-Output (income) ratio (C.O.R) is constant
 Existing plants are being operated at their full capacity
 Installation of new plants would be necessary in order to meet any change in demand for
consumer goods. As for available reserve capacity, production at plants can be increased without
making new investments
 There is surplus availability of resources to provide more plants and equipment needed to produce
consumer goods
 Flexibility in production (firms should be capable of providing quick response to any change in
demand for consumer goods)
 Existence of high degree of flexibility in production process is a precondition
 Credit money is considered to be elastic (Credit is considered to be elastic, such that funds for
induced investment are readily available) Conversely, if the economy is facing shortage of funds,
the rate of interest would be high and induced investment would be restricted
Table representation

 We use example of a furniture industry to explain this model

 Suppose that to produce a dining set of worth Rs. 100, 000, we require 5 plants, of worth Rs.
300,000 (assuming C.O.R is 1:3) which depicts the value of accelerator is 3. If demand for
furniture remains Rs. 100,000 then an investment of Rs. 300,000 would be required. If next year
there is no change in demand for dining set, means no need to add new stock of capital as existing
capacity is enough to produce existing demand for consumer durables
 Suppose that one plant becomes useless every year as a result of depreciation, therefore at the end
of every year replacement investment of Rs. 60000 (5 plants of worth Rs. 300,000 then cost of
each plant will be Rs60,000) must take place to replace old plant in order to maintain the existing
production capacity
 Let’s now, suppose that demand for dining set increased to Rs. 120,000. To meet this demand,
firms need stock of capital of Rs. 360,000 (i.e 120000 x 3) and new investment of Rs. 60,000 will

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 take place. With net investment of Rs.60,000 we need replacement expenditures of Rs. 60,000,
firm’s gross investment will raised to Rs.120,000
 We can see that a 20 percent increase in demand for consumer goods led to a change in gross
investment by 100 percent. This significant change in gross investment is the upshot of
accelerator principle.
 In this example
 C.O.R is 3:1
 Every year one plant has to be replaced
 Net Investment is 3 x change in output per year Gross Investment = New Investment +
Depreciation (or replacement cost)
 This shows how when output is increasing, the level of gross investment jumps up dramatically.
On the flipside, if output begins to drop, then we see a sharp decrease in the level of investment.
This is why it is called the accelerator effect (a change in output accelerates the change in the
investment)
Limitations
 The time and resources to adjust levels of capital stock are not considered. These costs may be
business costs due to installation of new machinery. In searching for the optimum level of capital
stock, firms may reach this point smoothly, rather than jump in between
 There may be spare capacity within the firm which means it does not need to increase net
investment by such a large amount – its existing resources could manage
 Accelerator principle works only if full employment level in an economy has not yet reached. If
once full employment has reached, then resources like labour and capital will no longer available
to produce consumer goods. Therefore, accelerator principle will become ineffective
 Accelerator principle is workable only if there is a constant C.O.R., which is not possible
practically
 Accelerator principle works only if there is a long term increase in demand for consumer goods.
If entrepreneurs are expecting that the rise in demand for consumer durables is temporary, they
will not make new investment immediately rather they will try to meet it by using existing plant
at its threshold capacity.

Interaction between multiplier and accelerator

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Table representation

 Table shows that year 1 and 2 are the years of economic expansion
 Year 3 is of peak (where the national output is at maximum)
 Years 4, 5 and 6 are of economic downturn where the output is decreasing
 Output reaches to its minimum level in Year 7
 Years 8 and 9 showing economy expansion as output is increasing
Conclusion
 Changing level of income and output represents a series of cyclical fluctuations

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Note
 Changes in national output are attributed towards the interaction of multiplier and accelerator
Business cycle
 Fluctuations of output that an economy experiences over a long period of time
There are different phases in each which one can analyse, recognise, and therefore use an
indicator for future events
Graphical representation

 The graph shows that, throughout economic history, there is often an upwards trend in the level of
economic growth
 Peaks and troughs form, but after each cycle, the level of Real GDP is greater than before
 Business cycles are economic fluctuations of an economy in long run. Such fluctuations
experienced through four distinct phases e.g peak, contraction, trough and revival or recovery
Characteristics of Peak (Boom Period)
 The economy is expanding, this means that output, income, employment, prices and profits
should all increase
 At this stage, banks issue credit more freely which facilitates firms to invest in increasing output
to meet the demands of consumers with higher income. Output grows, as does overall business
optimism
 A growing economy also means that there may be inflationary pressures, caused by high demand,
and insufficient levels of output. To temper these pressures, central banks are likely to increase
interest rates
 As output increases, there comes a point where it cannot expand further, which is when the cycle
reaches its peak
Characteristics of Downturn (Recession)
 At this stage, economic activity begins to slow down
 When demand begins to decrease, firms begin to scale back their production and investment plan
that shows a steady decline in output
 During downturn or recession, we generally do not expect increase in prices because deflation is a
recessionary indicator Banks reduce the credit they issue, firms cancel orders that they place, and
people begin to lose their jobs, which further decreases the level of aggregate demand
 This eventually takes the economy into a state of recession

Characteristics of Trough (Depression)

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  In this phase unemployment levels are high, incomes low, consumer demand low and investment
low
 The economy slips into a state where output remains very low
 There is an under-utilisation of resources as machinery lies dormant
 Business confidence is extremely low, as profits and prices go lower and lower
 Economic activity is at its lowest, meaning the business cycle is at its trough
Characteristics of Recovery (Revival)
 The depression does not last forever. Economy gradually converts itself into revival
 Consumers, who had postponed their expenditures in the hope of further cut in the prices, raise
their expenditures
 There would be an increase in levels of economic activity as demand begins to increase slightly.
 With an increase in demand, production increases, causing an increase in investment
 This causes a steady rise in output, incomes and business confidence
 This leads to an increase in investment, somewhat helped by banks increasing credit
 Assets in the economy begin to be utilised again, and levels of GNP increase once more
 During this process economy then enters a phase of recovery or revival, and the cycle continues.

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