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Multiplier Analysis

Definition of Multiplier
It is the ratio of the
change in national
Income due to change
in investment.

Understanding the definition


In economics, the multiplier effect refers to the
idea that an initial spending rise can lead to even
greater increase in national income. In other
words, an initial change in aggregate demand can
cause a further change in aggregate output for the
economy.
Investment multiplier is simply the multiplier effect
of an injection of investment into an economy.
In general, a multiplier shows how a sum injected
into an economy travels and generates more
output.

Multiplier
It must be noted that the extent of
the multiplier effect is dependent
upon the marginal propensity to
consume . Also that the multiplier
can work in reverse as well, so an
initial fall in spending can trigger
further falls in aggregate output.

Preliminary terms
Consumption function: It is a mathematical
expression of the relationship between
aggregate consumption expenditure (C)
and aggregate disposable income (Y)
expressed as C= f(Y).
C accounts for the largest proportion of the
aggregate demand in an economy and
plays a crucial role in the determination
of NI.

Consumption function
C = a + bY
C= Aggregate consumption expenditure
Y= total disposable Income
a = autonomous consumption. This is
the level of consumption that would
take place even if income was zero. If
an individual's income fell to zero some
of his existing spending could be
sustained by using savings.

Consumption function
b =marginal propensity to consume
(mpc). This is the change in
consumption divided by the change
in income. Simply, it is the
percentage of each additional rupee
earned that will be spent.
Mpc = C/ Y= b

Other Factors affecting


consumption function
Income is not the only factor influencing
consumption. C=f(Y, OF)where: C is
consumption expenditures, Y is income
(national or disposable), and now OF is
specified as other factors affecting
consumption. These other factors,
officially referred to as consumption
expenditures determinants, include a
range of influences.

Some of the more notable


consumption determinants are
consumer confidence, interest rates,
and wealth.
Consumer confidence is the general
optimism or pessimism the household
sector has about the state of the
economy. More optimism means more
consumption.

Interest rates affect the cost of borrowing the


funds used to purchase durable goods. Higher
interest rates mean less consumption. Wealth
is the financial and physical assets owned by
the household sector. More financial wealth
means more consumption, while more
physical assets mean less consumption.
These determinants cause consumption
expenditures to change even though income
does not change

Savings Function
Income that consumers earn but do not spend on
consumption will be saved in some form.
Y=C+S
If the consumption function is C = a + bYd
Then the savings function is given by:
S = -a + (1-b) Yd
With zero income consumers still spend the amount
"a"; this means they dissave "a".
Out of each 1 consumers spend "b"; this means
they save (1-b). e.g. if the marginal propensity to
consume is 0.8 then the marginal propensity to save
is 0.2

Investment Multiplier
Multiplier (m) = Y/I = 1/ 1-b
This relationship can be arrived at by
understanding the shift in the
aggregate demand function.
As the demand curve shifts upward
due to additional investment I, the
real income of the economy also
increases by Y

Assumptions of Multiplier
Effect
The marginal propensity to consume
remains constant throughout as the income
increases.
There is a net increase in investment over
the preceding year.
There is no any time-lag between the
increase in investment and the resultant
increment in income.
Excess capacity exists in the consumer
good industries

Shift in Aggregate demand


and Multiplier
In the two-sector model, a change in
aggregate demand is caused by a change
in consumption expenditure or in business
investment or in both.
Consumption expenditure is however more
stable function of income.
A change is assumed in the aggregate
demand function due to a change in the
business investment. (graphical
explanation)

Importance of Multiplier
effect
To explain the cumulative upward and
downward swings of trade cycles that
occur in a free enterprise capitalist
economy.
Its importance lies in the fiscal policy
to be pursued by the Government to
get out of the depression and achieve
the full state of employment and also
in the foreign trade policies

In a Two Sector Model


The role of Multiplier Effect in two
sector model is limited to :
a)Assessment of the overall possible
increase in the National Income due to
one-shotincrease in investment or
due to a single injection investment
b) To explain the Economic Growth of
the country.

The Multiplier Equation


derivation
We know the value
of national output equals
aggregate spending. Thus we have, Y = C+I
Let us now suppose that investment increases
by I. This will result in an increase in
aggregate consumption expenditure and real
national income. Hence, any change in
income Y is always equal to (Y) = C + I .
By substituting the values of C, we get the
final output as

multiplier = 1 / 1- MPC.

Working of Multiplier
process
Suppose an economy
is in equilibrium and

autonomous business investment increases


by Rs 100 million .
Due to this effect the total output increases
by Rs 100million. Further it also means an
additional income of Rs 100million has been
generated in the form of wages,interest and
profits.This makes the first round of income
generation.
Assuming MPC =0.8;total expenditure on
consumer goods=(100million ) X (0.8)=Rs
80million This expenditure generates income
worth Rs 80million in second round.

Working of Multiplier
process

Static Multiplier
Static Multiplier is also known by names viz.
comparative static multiplier ,
simultaneous multiplier , logical multiplier
, timeless multiplier , lagless multiplier .
It implies that change in investment causes
in income instantaneously.
It means that there is no time lag between
the change in investment and change in
income. The moment a Rupee is spent on
investment project, societys income
increases by a multiple of Re 1. K=1/1-MPC

Dynamic Multiplier
The change in the income as a result
of change in investment is not
instantaneous. There is a gradual
process by which income changes as
a result of change in investment.The
process of change in income involves
a time-lag.

Dynamic Multiplier
Since Multiplier process works through
the process of income generation and
consumption ,the time lag involved is the
gap between the change in income and
the change in consumption at different
stages. The Dynamic Multiplier is
essentially stage by stage computation of
the change in income resulting from the
change in investment till the full effect of
the multiplier is realised.

Limitations
1 ) Rate of multiplier dependent on rate of
MPC i.e. lower MPC rate implies lower rate
of multiplier and vice versa. This may not
be a practical situation for developing and
underdeveloped countries.
2) The process assumes no leakages in the
consumption out of new income which is
not practical since part of the additional
income may be spent on:

Limitations Contd..
Payment of Past Debts
Purchase of Existing Wealth
Import of goods and services etc.

This means no new demand for consumer


goods is generated here.
3. Non-availability of consumer goods and
services in line with the actual demand.
4. Full employment situation means no
additional real income.
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