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Closely connected to the Marginal Propensity to Consume. Keynes path breaking contribution to economic analysis. Popularly called Keynes Investment Multiplier.
Meaning of Multiplier
Relationship between initial increment in investment & final increment in aggregate income. Definition: Ratio of change in income to the change in investment. Shows the number of times an initial change in investment leads to multiple changes in consumption and ultimately aggregate income.
Original investment increases income in concerned industries and also in other industries of products demanded by the investment industries employees.
Explanation
MPC = 0, K = 1 i.e. nothing is spent by the consumers out of increased incomes. If MPC = 1, then MPS = 0 and K = i.e. consumers spend the whole of the increment of income on consumption and nothing is saved. Both are rare cases.
Summing Up
The size of the multiplier varies directly with the size of the marginal propensity to consume. When the marginal propensity to consume is high the multiplier is high, and when the marginal propensity to consume is low it is low.
Some Observations
Increase in consequences. investment has secondary
Result: increase in income larger than initial increase in investment. Such a multiple increase in spending not an easy process. The MPC depends on consumers reaction which is difficult to predict.
Multiplier works fully if the assumptions operate completely. Working of multiplier slows down by non fulfillment or partial fulfillment of the assumptions.
Maintenance of Investment
Various increments in income to be repeated at regular intervals. Break in continuity of investment will push national income back to the original level.
In open economy value of multiplier either more or less than its real value.
Longer the time lags fewer the secondary consumption expenditure and smaller the value of the multiplier.
3. Existence of Excess Capacity in consumer goods industries. 4. Existence of Elastic Supply of Capital.
MPC rarely equal to 1 or 100%. Due to several leakages from the income stream.
Savings
Means people do not spend entire, increment in income on consumer goods. Saved portion of the increased income limits value of the multiplier. Higher the propensity to save, lower shall be the value of the multiplier.
Other Leakages
Debt Cancellation: part of the new increment in income used to pay off debts. Accumulation of Idle Case Deposits: saved as idle bank deposits. Purchase of old stocks and securities: failure to spend on consumption. price inflation: dissipates the potential of higher income to increase consumption, income and employment. Taxes & Corporate savings: brings down propensity to consumer by reducing purchasing power through non availability of income with corporations and people.
Expenditure on Imports
to
domestic
income
and
Has no effect on consumption of domestic goods. An important leakages from the domestic income stream.
Reverse Multiplier
Higher the value of the multiplier greater shall be the reduction in aggregate income. If MPC = 1, then the reverse working of the multiplier would result in a complete collapse of economic activity. As normally MPC < 1 or K the effect of Reverse Multiplier is relatively less.
Criticism of Multiplier
1. No precise, predeterminable or mechanical relationship between investment and income.
2.
Multiplier concept creates problem of inequality between saving and investment because it assumes that what is not spent on consumption is not spent on anything at all as it is only hoarded.
Multiplier concept does not go along with Keynes definition of savings and investment as given by him in the The General Theory. Is one sided as it does not account for induced investment i.e. effect of increase in consumption on investment.
3.
4.
A theoretical concept.
An important instrument of economic policies. Has focused attention on investment as a major dynamic economic element for a country. Strengthened the case for public investment especially during depression and unemployment. Helped the government to formulate appropriate employment policy during depression.
Helpful to trace the course the business cycle and also to develop anti cyclical policies so as to smoothen business fluctuations, in the working of the economy.