Lecture 03

Concept of Multiplier
1. Kahn’s Employment Multiplier
2. Keynes Income/Investment Multiplier

1. Kahn’s Employment Multiplier

 The concept of multiplier was first developed by R.F Kahn in his articles “ The
relation of Home Investment to Unemployment” in the economic Journal of June
1931. Kahn’s multiplier was known as the Employment Multiplier”
 Example:- When government undertakes public works like roads, railways,
irrigation works, then people get employment. This is an initial stage of
employment. These people spend their income on consumption goods which leads
to increase in output of the concerned industries and provides further employment
to more people.
 Suppose government employs 3 thousand persons on public works, AS a result of
increase in consumer goods, 6 thousand more persons got employment in the
concerned industries. In this way, 9 thousand persons have been able to get
employment, that is three times more people are now employed, whereas initial
employment was only 3 thousand people. In other words, Khan’s Employment
Multiplier mean by the government undertaking public works people provided
more times employment as compared with initial employment 1
 Keyne’s Income & Investment Multiplier

Keynes took the idea from Khan’s Employment Multiplier and formulated
income and Investment Multiplier
 According to Keynes, there is relationship between investment and national
income. The level of investment effects the level of income. An increase in
investment rises the volume of N-income.
 The ratio of the total change in income to the initial change in investment is
called “Investment Multiplier”. The investment giving rise to income is
called “Multiplier Effect”.
First Formula: Y
K=
I

(i) K stands for Multiplier (ii) I Change in Investment (iii) Y Change in Income

Example:- If the Y increases by Rs.1000 as a result of an increase in the level of

investment by Rs.100 the multiplier would be.

K= Y
= K=1000/100=10
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Relationship Between Investment and the Marginal Propensity to Consume (MPC)

 The concept of investment multiplier is totally based on the concept of marginal

propensity to consume (MPC).
 According to Keynes, the MPC which determines the multiplier
 The higher the rate of the MPC, the larger the size of multiplier.
 Smaller the size of MPC, the smaller size of the multiplier.

Second Formula:- 1
K 1-b
(i) K is investment multiplier (ii) b stands for MPC
(ii) Multiplier is the inverse of one Minus MPC (1-MPC)

Example:- In an economy N-I is Rs.500 million. MPC is 4/5. Due to this MPC, consumption
is Rs.400 million.
Formula:- K= 1 1
= = K= 1
1-MPC =5 Multiplier
1- 4 1
5 5

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 Working of Multiplier

The investment multiplier describes that an increase to investment brings about a multiple
increase in aggregate income. Let us assume that the MPC of the country is 0.8 (Value of b)
and an increase in investment is Rs.100 million.
The MPC being 0.8, the multiplier (k) will be (1- 0.8/10)=5. This process is explained with
the help of table

Y Period Y MPC S
1 100 4/5=80 20
2 80 4/5=64 16
3 64 4/5=51.2 12.8
4 51.8 4/5=40.96 10.24

Explanation:- The table indicates, that when investment increases at RS.100 million,
which is consumed or spent on wage, interest, raw material, machinery, rent etc. the
matter does not end here. The recipient of this income will spend according to the MPC.
The MPC is shown 4/5 in column 3. This means Rs.80 million have been spent and Rs.20
million are saved. This income 80 million is invested again second time in business. This
process continues third and fourth period. Thus income continues to
increase.100+80+64+51.8 as explained in the table. 4
 Assumptions of the Multiplier Theory
1. The economy is assumed to be a closed economy
2. There are no changes in prices of commodities.
3. MPC is constant.
4. Induced investment is absent in this theory
5. In this theory, the change in investment refers a change in autonomous
investment
6. Consumption goods are available to meet effective demand
7. Resources of production are easily available within the country
Importance of Multiplier
(i) Investment:-This theory highlights the importance of investment in income and
employment theory. Fluctuations in income and employment are to be removed by
increasing investment
(ii) Trade Cycle:- Due to variations in the rate of investment, the multiplier process throws a
spot light on the different phases of the trade cycle.
(iii) Saving and Investment Equality:- It helps in bringing the equality between saving and
investment. An increase in investment leads to raise in income.
(iv) Formulation of Economic Policies
(a) To achieve full employment (b) to control trade cycles
(c ) Deficit Financing:- The multiplier highlights importance of deficit budgeting. This can be
removed by increased public expenditure through public investment programs. It increases
income and employment.
(d) Public Investment:- It refers to the state expenditure on public works and other works meant
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to increase public welfare. It is autonomous and is free from profit motive.
 Accelerator
The concept of accelerator was first introduced in economics by J-M Clark in 1917. It is an
older concept than the multiplier theory. It states that when income of a community
rises, it leads to an increase in demand for consumption goods. The rate of change in
demand for consumption goods leads to a greater change in demand for capital goods,
this relationship between an increase in demand for consumer goods and investment is
known as accelerator effect.
The multiplier shows the effect on income due to change in investment whereas the
accelerator shows the effect of change in consumption on induced investment.
Therefore, the accelerator is opposite to multiplier.
Formula:- K
=W
Y
K stands for stock of Capital in period or investment
Y stands for output or N-I
W shows capital output Ratio (C O R)
The value of accelerator could also be 0 or 1. When the induced consumption does not
induce the investment, the accelerator would be zero and it is some time equal to
induced consumption.
A machine worth Rs.1800 are required to meet the demand resulting from the increased
consumption of Rs.900. The numerical value of accelerator would be.
K =W 1800 =2 6
Y 900
 The concept of accelerator is explained with the table
Needed Replacement Net Gross
Period Demand Required Stock of Expenditure Investment Investment
for Cloth Machine Capital
1 500 5-1=04 1500 Rs.300 0 300
2 600 6-1=5 1800 Rs.300 300 600
3 800 8-1=7 2400 Rs.300 600 900
4 1100 11 3300 Rs.300 900 1200

In the first year the induced consumption demand for cloth is Rs.500. To produce cloth
worth Rs.100 one machine worth Rs.300 is required. For demand worth Rs.500 five
machines worth Rs.1500 are needed. After each year, one machine becomes useless
due to wear and tear. It will be replaced by purchasing new one In the 2 nd year demand
for cloth increases to Rs.600. To produce cloth Rs.600, we need 6 machines worth
Rs.1800. Replacement expenditure of old one Rs.300 and one more new machine
Rs.300, total gross investment becomes Rs.600/- Same continues up to 4 th year. It
indicates net investmen Rs.900 in column 6 and gross investment Rs.1200 in column 7.

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 Assumptions
The acceleration principle is based upon the following assumptions.
(i) It assumes a constant capital output ratio
(ii) It assumes that resources are easily available
(iii) It assumes that there is no excess
(iv) It assumes that increased demand is permanent
(v) It assumes that there is elastic supply of credit and capital
(vi) It assumes that an increase in output leads to a rise in net
investment

Conclusion of Accelerator Theory

From the theory of accelerator, it is observed how the induced investment
increases due to a change in the induced consumption. Further, more the
change in the capital stock of country takes place due to the change in
induced investment.

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Limitations of Accelerator Theory
(i) Temporary Change in Demand:- It works when there is a permanent change in
demand. When rise in demand is temporary, this does not induce to increase
investment.
(ii) Business Expectation:- The business sector invests capital keeping in view the
expected rate of profitability or the MPC. So, business expectations in this
sense plays a vital role in determining the induced investment
(iii) No Change in Aggregate Demand:-The increase in demand may lead to a
reduction of demand for a substitute. This theory operates when aggregate
demand is same.
(iv) Concept of Capital-Output Ration:- The concept of the accelerator explains the
capital-output ratio for the whole economy. In reality this ratio can not be
generated for whole economy.. But ratio varies from one industry to an other
industry.
(v) Non availability of financial resources:- the increase induced consumption
requires additional investment. Lacking loan facilities create hindrances in new
investment