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MultiplierandAccelerator

MultiplierandAccelerator
(DeterminationofNationalIncomeContinued)

THEMULTIPLIER:
KeynesMultiplierTheorygivesgreatimportancetoincreaseinpublicinvestmentand
governmentspendingforraisingthelevelofincomeandemployment.Bothconsumptionand
investmentcreateemployment.Butbothhavecomplementaryrelationshipwithoneanother.
Wheninvestmentincreases,consumptionincreasestooandhelpsincreatingemployment.It
isonlywhentheleveloffullemploymenthasbeenreachedthatinvestmentandconsumption
becomecompetitiveinsteadofbeingcomplementarythenincreaseinonewillreducethe
other,onewillbeattheexpenseoftheother.
KahnsEmploymentMultiplier:
KahnsMultiplierisknownasEmploymentMultiplier,andKeynesMultiplierisknownas
InvestmentMultiplier.AccordingtoKahnsEmploymentMultiplier,whengovernment
undertakespublicworkslikeroads,railways,irrigationworksthenpeoplegetemployment.
Thisisinitialorprimaryemployment.Thesepeoplethenspendtheirincomeonconsumption
goods.Asaresult,demandforconsumptiongoodsincreases,whichleadstoincreaseinthe
outputofconcernedindustrieswhichprovidesfurtheremploymenttomorepeople.Butthe
processdoesnotendhere.Theentrepreneursandworkersinsuchindustries,inwhich
investmenthasbeenmade,alsospendtheirnewlyobtainedincomewhichresultsinincreasing
outputandemploymentopportunities.Inthisway,weseethatthetotalemploymentso
generatedismanytimesmorethantheprimaryemployment.
Supposethegovernmentemploys300,000personsonpublicworksand,asaresultof
increaseinconsumergoods,600,000morepersonsgetemploymentintheconcerned
industries.Inthisway,900,000personshavebeenabletogetemployment,thatis,threetimes
morepeoplearenowemployed.Inotherwords,Kahnsemploymentmultipliermeansthatby
thegovernmentundertakingpublicworksmanymoretimestotalemploymentisprovidedas
comparedwithinitialemployment.
KeynesIncomeorInvestmentMultiplier:
Keynesincomemultipliertellsusthatagivenincreaseininvestmentultimatelycreatestotal
incomewhichismanytimestheinitialincreasesinincomeresultingfromthatinvestment.That
iswhyitiscalledincomemultiplierorinvestmentmultiplier.Incomemultiplierindicateshow
manytimesthetotalincomeincreasesbyagiveninitialinvestment.
SupposeRs.100millionareinvestedinpublicworksandasaresultthereisanincreaseofRs.
300millioninincome.Inthiscase,incomehasbeenincreased3times,i.e.,themultiplieris3.
IfIrepresentsincreaseininvestment,YindicatesincreaseinincomeandKisthemultiplier,
thentheequationofmultiplierisasfollows:
(i)

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Themultiplieristhenumericalcoefficientshowinghowlargeanincreaseinincomewillresult
fromeachincreaseininvestment.Themultiplieristhenumberbywhichthechangein
investmentmustbemultipliedinordertogettheresultingchangeinincome.Itistheratioof
changeinincometothechangeininvestment.IfaninvestmentofRs.50millionincreases
incomebyRs.150million,theincomemultiplieris3andifRs.200million,themultiplieris4
andsoon.
Inthefollowingmultiplierequation,therelationshipbetweenincomeandinvestmentis
determinedthroughmarginalpropensitytoconsume:
(ii)
Where:

(mps:MarginalPropensitytoSave)
Therefore,thethirdmultiplierequationis:
(iii)
Itshouldbenotedthatthesizeofmultipliervariesdirectlywiththesizeofmpc.Whenthempc
ishigh,themultiplierishighandwhenthempcislow,themultiplierisalsolow.
Themultiplierworksnotonlyinmoneytermsbutalsoinrealterms.Inotherwords,the
increaseinincometakesplacenotonlyintheformofmoneybutintheformofgoodsand
services.
Example1:
mpcis
InitialinvestmentisRs.1,000million
Required:
(a)Multiplier,
(b)Marginalpropensitytosave,
(c)Increaseinthelevelofnationalincome,and
(d)Conclusion.
Solution:
(a)Multiplier(K):

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(b)MarginalPropensitytoSave(mps):

(c)IncreaseinthelevelofNI:

(d)Conclusion:
Fromtheaboveexample,wecanseethatwithaninitialprimaryinvestmentof
Rs.1,000million,withanmpcatandmultiplierat4,givesrisetoanincrease
ofRs.4,000millioninthelevelofnationalincome.

Example2:
Calculatempc,mpsandmultiplier(K):
mpc
4/6

?
?
1
0

mps
?
?

1/7
?
?

K
?
?
4
?
?
?

mpc

mps

Solution:

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4/6

2/6

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1/7

(infinity)*

1**

*Ifthempcis1,thempswillbezeroandthemultiplierwillbeinfinityandagivendoseof
investment(letsay,Rs.1,000million)willautomaticallycreatefullemployment.
**Ifthempcis0,thempswillbe1andthemultiplierwillbe1sothattotalincreaseinincomewill
justequaltheincreaseinprimaryinvestment.

Keynesmultipliertheoryisalsoveryhelpfulinthedeterminationofnationalincome.Inhis
book,GeneralTheoryofEmployment,InterestandMoney,hehascontradictedtheviewpoint
oftheclassicaleconomists.Heisoftheopinionthatifaneconomyoperatesatalevelof
equilibriumitisnotnecessarythatthereshouldbeahighlevelofemploymentinacountry.Itis
justpossiblethattheremaybemillionsofpeopleunemployed.SoaccordingtoKeynes,ifany
countrywishestoachievelevelofemployment,itcanonlydosothroughthechangesinthe
magnitudeofinvestment.
AccordingtoKeynestheory,therearetwomainmethodsofmeasuringtheequilibriumlevelof
NI,i.e.:
(a)TheADASApproach,and
(b)TheSavingInvestmentApproach
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(a)ADASApproach:Forexplainingthedeterminationoflevelofincomeinatwosector
economy,weassumeaneconomyinwhichthereisnointernationaltrade,no
governmentroleandinwhichcorporationsretainnoearnings.Inthissimplestmodelof
economy,thelevelofincomeisdeterminedatapointwheretheADintersectstheAS.It
isdepictedasbelow:

Intheabovediagram,thenationalincomeisdeterminedatthepointwhereADcurve
(C+I)cutstheAScurve(C+S),i.e.,atE.Themultipliereffectisalsoshowninthis
diagram.ThecurveCrepresentsthempcwhichisassumedtobe.Thatiswhythe
slopeofcurveCis0.5.SincetheADcurve(C+I)cutsthe45oanglelineatE,OY1is
thelevelofincomedetermined.IfnowinvestmentisincreasedtoEH(I)wecanfind
outtheincreaseinincome(Y).AsaresultofinvestmentEH,theADcurveshifts
upwardstoC+I.ThisnewADcurvecutstheAScurve(45oangleline)atF,sothat
OY2incomeisdetermined.Thus,incomeincreasesbyY1Y2asaresultofinvestment
increaseofEH,which(Y1Y2)isdoubleofEH.
Itisclear,therefore,thatthemultiplieris2.Itisalsocalculatedasbelow:

(a)SavingInvestmentApproach:Inordertosimplifytheanalysisofincome
determinationweimagineaneconomy(1)wheretherearenotaxesleviedbythe
government,(2)thecorporationsretainnoearnings,and(3)therearenochangesinthe
levelofprices.TheequilibriumlevelofNIisdeterminedatapointwhereplannedor
intendedsavingisequaltoplannedorintendedinvestment,orinotherwords,wherethe
savingintersecttheinvestment.Itisfurtherexplainedwiththehelpoffollowingdiagram:
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Theabovediagramshowsthemultipliereffectofanincreaseininvestmentonthe
equilibriumlevelofincome.SSisthesupplycurveandIIistheinvestmentcurve
showingthetotallevelofinvestmentofOI.Thesetwocurvesintersecteachotheratthe
equilibriumpointEwhereisincomeisOY1.Ifnowthereisachangeininvestmentfrom
OItoOI,i.e.,anincreaseofII,thentheIIcurvewillshifttothepositionofIIandthe
twocurvesIIandSSintersecteachotheratthenewequilibriumpointE,wherethe
incomeisOY2.Nowitisclearthatwhenmpsis,anincreaseininvestmentbyII(let
sayRs.10million)hasledtotheincreaseinincomebyY1Y2(letsayRs.30million).
Obviouslythevalueofthemultiplierisequalto3.
LimitationsofMultiplier:
(a)Efficiencyofproduction:Iftheproductionsystemofthecountrycannotcopewith
increaseddemandforconsumptiongoodsandmakethemreadilyavailable,theincomes
generatedwillnotbespentasvisualised.Asaresult,thempcmaydecline.
(b)Regularinvestment:Thevalueofthemultiplierwillalsodependonregularlyrepeated
investments.Asteadilyincreasinginvestmentisessentialtomaintainthetempoof
economicactivity.
(c)Multiplierperiod:Successivedosesofinvestmentmustbeinjectedatsuitable
intervalsifthemultipliereffectisnottobelost.
(d)Fullemploymentceiling:Assoonasfullemploymentoftheidleresourcesis
achieved,furtherbeneficialeffectofthemultiplierwillpracticallycease.
LeakagesofIncomeStreamandTheirEffectontheMultiplier:
Asweknowthatasincomeincreases,consumptiondoesnotincreasetothesameextentor
proportionately,becauseapartoftheincomeissaved.Thepartoftheincomethatissavedis
asifaleakagefromtheflowofincomestream.Theseleakagesobstructthegrowthofnational
income.Intheabsenceoftheseleakages,mpcwouldhavebeenunity.Theconsumption
expenditurewouldhaveincreased100percentoftheincreaseinincomeandtherewouldhave
beenfullemployment.Thefollowingaretheprincipalleakages:
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(a)Payingoffdebts:Itgenerallyhappensthatapersonhastopayadebttoabankorto
anotherperson.Apartofhisincomegoesoutinrepayingsuchdebtsandisnotutilised
eitherinconsumptionorinproductiveactivity.Incomeusedtopayoffdebtsdisappears
fromtheincomestream.If,however,thecreditorusesthisamountinbuyingconsumer
goodsorinsomeproductiveactivity,thenthissumwillgeneratesomeincome,
otherwisenot.
(b)Idlecashbalances:Itiswellknownthatpeoplekeepwiththemreadycashwhichis
neitherusedproductivelynorinpurchasingconsumergoods.Keyneshasmentioned
threemotivesforholdingreadycashforliquiditypreference,viz.,transactionsmotive,
precautionarymotiveandspeculativemotive.Thismeansthattherespentpartof
incomegoesondecreasing.Inthisway,apartoftheinitialexpenditureleaksoutofthe
incomestream.
(c)Imports:Thepartofthemoneyspentbycountryforimportinggoodsalsoleaksoutof
thecountrysincomestream.Itdoesnotencourageorsupportanybusinessorindustry
inthecountry.Thisisspeciallysoiftheimportsdonothelpthetradeandindustryofthe
countryoriftheyarenotusedforexportpromotion.Thenetimportisaleakage.
(d)Purchaseofexistingsecurities:Somepeoplepurchasesecurities(saving
certificates)fromothersandthesellerofsecuritiescanhoardthismoney.Thismoney
alsoleaksoutoftheincomestream.Thismayalsobevalidincaseofpurchaseof
shares,debentures,bonds,insurancepolicy,orsomeotherfinancialinvestment.Ifthis
investedmoneyisnotusedinproductiveareas,therewillbealeakageintheincome
stream.
(e)Priceinflation:Inflationarysituationisalsoresponsibleforleakage.Insuchasituation,
investmentdoesnothelpingeneratingemploymentorincreasingincome.Ifthereis
alreadyfullemploymentinthecountry,increaseininvestment,farfromincreasing
demandforconsumergoods,itdecreasesitasaresultofwhichemploymentinthe
consumergoodsindustriescontractsanddemandforcapitalgoodsdecreases.
Whateverincreaseinincomethereis,itisspentinhighpricesanditdoesnothelpin
creatingincomeandemployment.
Asaresultofleakagesofincomefromthemainincomestreamofthecountry,themultiplier
effectoftheprimaryorinitialinvestmentinincreasingincomeisreduced.Ifsomehowthese
leakagesareplugged,themultipliereffectofinvestmentingeneratingincomeandemployment
wouldincrease.Iftheycannotbepluggedaltogether,theyshouldbereducedorthepropensity
toconsumeshouldbeincreasedorpropensitytosaveshouldbereduced,otherwisethenew
investmentwillnothavefulleffectinincreasingincomeandemployment.
ImportanceofMultiplier:
KeynesprincipleofmultiplierhasagreatroleinremovingtheGreatDepressionof192934.
Thesedaysgovernmentsareactivelyinterfereintheeconomicaffairsofthecommunity
throughmultiplier.Itsimportanceisfurtherexplainedasbelow:
1.Themultiplierprinciplefocusesontheimportanceofpublicinvestment,whichisthe
keytoremoveunemploymentduringthedaysofdepression.AninvestmentofRs.1
millioncancreateincomeandemploymentworthmanytimes,andcanhelpthe
governmenttoremoveunemploymentfromthecountry.
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2.Duringthedaysofdepression,theprivateentrepreneursarediscouragedtoinvestin
theeconomy.Therefore,tofillthisgap,thegovernmentcomesforwardand
undertakestheinvestmentinherownhands.Hence,thedemandforconsumergoods
increasesandalsothelevelofNIandemploymentincreasesonaccountoftheworking
ofthemultiplier.
3.Whenthedemandforgoodsincreasesandincomesriseowingtogovernment
investment,theprofitexpectationsoftheentrepreneursgoupandasaresultthe
MECrises.
4.Whenthegovernmentmakesinvestmentinpublicworkstofightdepressionand
unemployment,privateinvestmentisencouragedonaccountoftheoperationofthe
multiplier.Theconfidenceofprivateinvestorsisrestored,andhencehelpsinfurther
removingtheeconomicdepressionofthecountry.
AssumptionsofMultiplier:
Thefollowingcertainessentialconditions/assumptionsfortheoperationofmultiplier:
1. Thesupplycurveofoutputshouldbeelastic.Inotherwords,whendemandfor
certaingoodsorservicesincreases,itssupplycanbeincreasedwithoutmuchdifficulty.
2. Thereisexcessproductivecapacityinconsumergoodsindustries,sothatthe
supplyofgoodscanbeeasilyincreasedwhendemandincreases.
3. Thesupplyofrawmaterialsandworkingcapitalshouldalsobeelastic.
4. Thereshouldbeinvoluntaryunemployment.Thatis,therearepeoplewhowant
workattheprevailingwagerate,butarenotgettingit.
CriticismonKeynesMultiplierTheory:
Manyeconomistsincludingtheclassicaleconomistsandtheeconomistsfromthirdworld
countrieshavestronglycriticisetheKeynesMultiplierTheory.Itisexplainedinbriefasbelow:
1. Keynesmultipliertheoryassumesthatthesupplyofoutput,rawmaterialsandworking
capitaliselastic,i.e.,itcanbeincreasedwheneverrequired.But,accordingtocritics,this
conditioncannotbefulfilledinanunderdevelopedcountry(UDC),wherethereisa
continuousviciouscycleofpoverty.Thewholeeconomyisbasedonagriculture,and
thereisadearthofcapitalequipment,skilllabourandtechnology.Theexisting
industriescannotfulfilltheincreaseddemand.Moreover,thegovernmentisso
poortoinvestinpublicworks.
2. AccordingtoKeynesmultipliertheory,thereisexcessproductivecapacityinconsumer
goodsindustries.Butaccordingtocritics,thereisalittleexcessproductivecapacity
inpoorcountriestherefore,thistheorycannotbeappliedtoUDCs.
3. AnotherconditionofKeynestheoryisthatthereshouldbeinvoluntaryunemployment.
Thatis,therearepeoplewhowantworkattheprevailingwagerate,butarenotgettingit.
Whereas,inUDCs,thereisdisguisedunemployment,andmostoftheworkersare
selfemployed,therefore,thisconditioncannotbefulfilledinsuchcountries.
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4. Accordingtocritics,thistheorycanonlybeappliedtoeconomicallyadvancedand
highlyindustrialisedcountries,andcannotbeappliedtounderdeveloped
countries,whicharepredominantlyagriculturalcountries.InUDCs,theheavyplantand
machineries,andskilledlabourarenoteasilyavailableandthesupplycannotbe
increasedquickly.

THEACCELERATOR:
Themultiplierdescribestherelationshipbetweeninvestmentandincome,i.e.,theeffectof
investmentonincome.Themultiplierconceptisconcernedwithoriginalinvestmentasa
stimulustoconsumptionandtherebytoincomeandemployment.Butinthisconcept,weare
notconcernedabouttheeffectofincomeoninvestment.Thiseffectiscoveredbythe
accelerator.Thetermacceleratorshouldnotbeconfusedwiththeacceleratorincars.It
doesnotmaketheinvestmenttogrowfasterandfaster.
ThetermacceleratorisassociatedwiththenameofJ.M.Clarkintheyear1914.ithasbeen
provedapowerfultoolofeconomicanalysissincethen.Keynes,astonishingly,hasaltogether
ignoredthisconcept.Thatiswhy,theconceptofacceleratorisnotconsideredthepartof
Keynesiantheory.
Accordingtheprincipleofaccelerator,whenincomeincreases,peoplesspendingpower
increasestheirconsumptionincreasesandconsequentlythedemandforconsumergoods
increases.Inordertomeetthisenhanceddemand,investmentmustincreasetoraisethe
productivecapacityofthecommunity.Initially,however,theincreaseddemandwillbemetby
overworkingtheexistingplantsandmachinery.Allthisleadstoincreaseinprofitswhichwill
induceentrepreneurstoexpandtheirplantsbyincreasingtheirinvestments.Thusarisein
incomeleadstoafurtherinducedinvestment.Theacceleratoristhenumericalvalueofthe
relationbetweenanincreaseinincomeandtheresultingincreaseininvestment.
(FiguresinRs.000)
Years
2007
2008

Demand
500
500

2009

800

2010

1000

2011

1000

2012

800

Required
Stockof
Capital
5
machines
1500
5
machines
1500
8
machines
2400
10
machines
3000
10
machines
3000
8
machines
2400

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Replacement
Cost

Net
Investment

1machine
300

0machine

300

1machine
300

0machine

300

3machines
900

1200

2machines
600

900

0machine

300

2
machines
600

300

1machine
300
1machine
300
1machine
300
1machine
300

Gross
Investment

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Costpermachine:Rs.300,000permachine
Intheaboveexample,supposewearelivinginaworld,wheretheonlycommodityproducedis
cloth.FurthersupposethattoproduceclothRs.100,000,werequireonemachineworthRs.
300,000,whichmeansthatthevalueoftheacceleratoris3(i.e.,thecapitaloutputratiois1:3).
Thatis,ifdemandrisesbyRs.100,000,additionalinvestmentworthRs.300,000takesplace.
Iftheexistinglevelofdemandforclothremainsconstant,letussay,atRs.500,000,thento
producethismuchclothweneedfivemachinesworthRs.1.5million.Attheendofoneyear,
letussuppose,thatonemachinebecomesuselessasaresultofwearandtear,sothatatthe
endofoneyear,agrossinvestmentofRs.300,000musttakeplacetoreplacetheoldmachine
inorderthatthestockofcapitaliscapableofproducingoutputworthRs.500,000.
Inthethirdperiod,i.e.,theyear2009,demandrisestoRs.800,000.Toproduceoutputworth
Rs.800,000,weneed8machines.Butourpreviousstockconsistedofonly5machines.Thus
ifwearetoproduceoutputworthRs.800,000,wemustinstall3newmachines,worthRs.
900,000.Thenetinvestmentfortheyear2009willbeRs.900,000andwiththereplacement
costofonemachineRs.300,000,ourgrossinvestmentjumpsfromRs.300,000intheyear
2008toRs.1.2millionintheyear2009.A60percentincreaseindemandledtoa400per
centincreaseingrossinvestment.Herewehaveaglimpseofthepowerfuldestabilisingroleof
accelerator.
AssumptionsoftheAccelerator:
1. Undertheprincipleofaccelerator,itisassumedthatthereisnoexcesscapacity
existingintheconsumergoodsindustries.Nomachinesarelyingidleandshift
workingisnotpossible.
2. Incapitalgoodsindustries,ithasbeenassumedthatthereisanexistenceof
surpluscapacity.Ifthereisnoexcesscapacityincapitalgoodsindustries,increased
demandformachinescouldnotleadtoincreaseinthesupplyofmachines.
3. Outputisflexible.Themachinemakingindustryorcapitalgoodsindustrycanincrease
itsoutputwheneverdesired.
4. Thesizeoftheacceleratordoesnotremainconstantovertime.Itvaluewillbe
affectedbythebusinessmenscalculationsregardingtheprofitabilityofinstallingnew
plantstomakemoremachinesonthebasisoftheirprobableworkinglife.
5. Thedemandformachineswillremainstableinthefuture,althoughtheincreasein
demandhassuddenlycroppedup.
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