Theory of Multiplier

What Is Multiplier ?

Its is an important tool to analyze: The magnitude (quantum) change in National Income because of change in aggregate demand. Effects of changes in the Monetary & Budgetary Policy of Government.

Shift in the aggregate demand in a modern economy may be caused by : Business Investment Government Spending Foreign trade (X+M)
Therefore, multiplier is the tool analyze magnitude of the change because of change in aggregate demand based on above mentioned area.

Business Investment Multiplier

It is the ratio of final change in equilibrium of national income to the initial change in autonomous Investment.

As per Keynes, the increment (decrement) in income would be several times to the initial increment (decrement) in autonomous investment. m= Y I

If an initial investment of Rs.50/-crores leads to an increase in income by Rs.300/- crores m= Y/ I = 300/50 m = 6 It suggests that every increment of Rs.1 in investment brings about an increase in income of the order of Rs.6/Resultantly, a small increment in investment by the govt. during recession but also provide help for recovery and prosperity of economic system.

Autonomous Investment Rs.100 Million, b = 80% Rounds of Income Generation First Round Second Round Third Round Fourth Round Fifth Round Last Round Total Income Consumer Spending (Rs.Million) -80 64 51.20 40.96 -Income Generation (Rs.Million) 100 80 64 51.20 40.96 00.00 500.00

Working of Multiplier Process

Graphical Representation
Initial equilibrium point is E where AD intersects AS at Y1 equilibrium level of income.

Y- axis Consumption and Investment

Y=C+S F C+I+ E M R I
AD

C+I

If autonomous investment takes place pushing up the AD curve to C+I+ I. Now new equilibrium is At point F at Y2 equilibrium level of income.

Y1 Income

Y2

As a result of an increase in investment by FM the level of income rises by ER. The increase in Income ER>FM

It reflects that a given autonomous change in investment will be associated with a change in income larger than itself.

Two Limiting Cases of the Value of Multiplier

1. MPC = 1 (Whole income is consumed) Multiplier will be infinite 2. MPC = 0 (Whole income is saved) Multiplier = 1

MPC is > 0 but < 1 m is > 1 but <

Assumptions
1. In short run MPC is remain constant. 2. Keynes assumed there is no time-lag between the increase in investment and resultant increment in income. It is known as instantaneous multiplier. 3. Excess capacity exist in the consumer goods industries. So that increase of demand will not bring inflationary pressure.

Types of Multiplier : Static Multiplier

Static Multiplier does not consider the time path of change in income.

Assumptions: There is no time lag between the receipt of income and its disposal in the form of consumption. Investment multiplier varies directly with the MPC (Higher the MPC (b) greater will be the magnitude of m and vice-a versa).

Static Multiplier
Algebraic Derivation :

Y = C+I

Investment increases by I Consumption increases by C Y = C+ I As change in investment is considered as independent to income while changes in consumption is function of income. AsC=b Y

Thus Y=

b Y+ I Yb Y = Y (1-b) = I Y=

1 I 1-b Y = 1 = m or I 1-b m = 1_ = 1 1-b 1-MPC

OR

=1 MPS

Example

I = 200 crore C = 80+0.75Y What will be the equilibrium level of Income ? What will be the increase in national income if: investment increases by Rs. 25 crore

Y = C+I C= 80+0.75Y I = 200 crore

Y= 80+0.75Y+200 Y(1-0.75Y) = 80+200 =280 0.25=280 Y=280 x 100 = 1120 25

m =

1 1-b

= __1___ 1-0.75

= 4

I Rs. 25 crore x 4 = 100 crore

Dynamic Multiplier

Change in income as a result of change in investment is not instant. There is gradual process by which income changes as a result of change in investment. The gradual process involves the time single period time-lag on which consumption is based on.

Consumption in period t depends upon the income in t-1. Investment is assumed to be continuous,
Symbolically-

Yt = Ct+It Ct = a+byt-1 It = It Yt = a+byt-1+It

Example

I = Rs.70 Crore, C = 60+0.80Yd i) Find the Equilibrium level of Income when there is a Rs.10 crore increase in autonomous planned investment increase from Rs. 70 crore to 80 crore. ii) Establish the multiplier effect of the Rs.10 crore increase in autonomous spending

Solution

i)

Y = C+I = 60 + 0.80Y + 70 = 130 +0.80Y

Y -0.80Y = 130 or Y(1-0.80) =130 = 130/0.2 = Rs.650 Crore

ii)

Y = C+I = 60 +0.80Y +80 = 140 +0.80Y Y-0.80Y =140 or Y = 140/0.2 = Rs. 700

As a result of 10 crore investment income rises by Rs.50 crore. Therefore, Multiplier effect m= 1/1-b = 1/1-0.80 = 1/0.2 = 5

Problem

Assuming the following values of MPC find out the MPS and Multiplier. MPC = a) 0.20, b)0.50, c)0.90 As - m = 1/MPS As - MPC+MPS =1

Use of Multiplier

Multiplier is important tool to determine investment requirement for a certain planned growth in national income.

Planned Growth ( Y) = Rs. 100billion Multiplier =5 Invest men Requirement = Y/m = 100/5

= 20 billion

Limitation of Multiplier

This theory does not work practically due to given reasons: Leakage from the income stream:

Multiplier is based on MPC. Spending takes place as per increased consumption which leads increase in income due to increase in autonomous investment.

In practice this assumption does not hold in reality because people spend their additional income on non-consumption item. Such expenses are known as Leakages because of given reasons: Payment of the Past Debts Purchase of existing wealth Import of Goods and Services

1.
2. 3.

Non Availability of Consumer goods and Services: There is time-lag between demand and supply. In general supply of goods does not follow instantly the rise in Demand. Full Employment Situation: Multiplier does not work in this situation. When resources of the country are fully employed further production will not be possible. Hence additional investment will only lead to INFLATION,

 Government

Multiplier :

Balanced Budget Multiplier

Tax Multiplier

Three Sector Model : Income Determination Y = C+I+G Redefined C as: C = a+bYd Yd = Y-T C= a+b(Y-T)

Equilibrium level of Income:

Y = C+ I +G Y = a +b(Y-T) +I+G Y=a + b Y bT + I +G (1-b)Y = a-bT +I+G Y = 1 ( a b T + I +G) 1-b

C = 100+ 0.75Yd I = 200 G = T = 100 Y = 1 ( a b T + I +G) 1-b Y = 1 [100 (0.75 x100) +200+100] 1-0.75

= 1/0.25 (100-75 +200+100) = 4(325) = 1300

There is no Tax imposition only Gov. expenditure is in economy: C = 100 +0.75 I = 200 G (Exp.) =100 Y = a + bY+ I + G Y = 100+0.75+200+100 (1 0.75)Y =100+200+100 Y = 400/0.25 Y =1600

Multiplier Three Sector Model

Three Sector economy Y = C+I+G This multiplier known as Government expenditure multiplier. In this case, the equilibrium of national income changes because of change in Government expenditure

Derivation
Y = 1 ( a b T + I +G) (1) 1-b Gov. Exp. Increases by G Y Y + Y = 1 ( a bT + I + G + G ) (2) 1-b Eq.2- 1Eq. Y = 1 /1-b ( G)

Gm = Y/ G = 1 /1-b

Tax Multiplier

Equilibrium level of Income:

Y = C+ I +G Y = a +b(Y-T) +I+G Y=a + bY bT + I +G (1-b)Y = a-bT +I+G Y = 1 ( a b T + I +G) 1-b

Y = 1/1-b [ a b T + I +G]

Eq. (1)

After T Y Y + Y = 1/1-b [ a b(T+ T)+ I +G] = 1/1-b [a- bT- b T + I + G] Eq. 2 Eq.1 Y = 1 /1-b (-b T) Y = (-b T/ 1-b) Tm = Y/ T = -b /1-b

Eq. (2)

Tax multiplier is always (-) because rise in income tax has negative impact on national income and vice-a versa.

Example Tax Multiplier

Equilibrium with and without Taxes

Assumed - C = 500 + 0.7(Y-T), I=1000, G=500, T=500

Solution

Equilibrium when taxes = 0. Y = 1/1-0.7(500+1000+500) = 3.333 x 2000 = 6667 And since T=500 Y = a +b(Y-T) +I+G Y = a + bY bT + I +G

C = 500 + 0.7 x Y - 0.7 x 500

= 500 + 0.7 x Y - 350 = 150 + 0.7xY New equilibrium income Y = 1/1-0.7(150+1000+500) = 3.333x1650 = 5500 Introduction of a tax of 500 reduced equilibrium income by 1167.

Tax multiplier = - b/1-b = -0.7/1-0.7 = -0.7/0.3 = 2.333 TM = -2.333 Equilibrium Y = 2.333 x 500 = 1167

Tax multiplier is always (-) because rise in income tax has negative impact on national income and vice-a versa.

Balanced Budget Multiplier

When a Govt. adopts a balanced budget policy, it spends only as much as it collects through taxation. It is always equal to unity. It implies that national income increases exactly by the amount of increase in the government expenditure. Because-

Y + G

Y T

= 1 + -b = 1 1-b 1-b

Balanced Budget Multiplier : Example

ii) Suppose Govt. finances the entire 10 crore expenditure from lump-sum taxation. What is new equilibrium level of income.

Solution I = 60 & G = 10 T = Rs.10 crore C = 40+0.80Y(Y-T)

= 40+0.80Y-0.80X10 = 32+0.80Y = 32+0.80Y+60+10 = 102 +0.80Y =(1- 0.20)Y =102 Y = 102/0.20 = Rs.510 crore

Four Sector National Income

National Income equilibrium in Four sector: Y = C+I+G+(X-M)

Y = a+bYd+I+G+X-(M+mY) (M = M+mY)

= a +b(Y-T)+I+G+X-(M+mY) or (1-b+m)Y = a +I+G+X-bT-M

Y = 1/1-b+m (a+I+G+X-bT-M)

Example

Suppose Y= C+I+G+(X-M) C = 100+0.75Yd

I = 50, G = 50, X=10, M+m =5+0.1Y, and T = 50

Find Equilibrium level of Income

Solutiona +b(Y-T)+I+G+X-(M+mY) Y=100+ 0.75 (Y-50) + 50 + 50 +10- (5+0.1Y) Y = 1/1-b+m (a+I+G+X-bT-M) = (1-0.75+0.1)Y = 100-0.75x50+105 =167.50 167.5/0.35 = 478.57 Y = 478.57

Foreign Trade Multiplier

Equilibrium of National IncomeY = 1/1-b+m (a + I + G + X-bT-M )

Suppose level of export rises from X to X level of income equilibrium is

Eq.1

then the new

Y+ Y = 1/1-b+m (a + I+ G + X+ X - bT- M) Eq. 2

Eq. 2 Eq. 1 =

Y/ X = 1/1-b+m

If b = 0.75 What will be multiplier in closed economym = 1/1-b m= 1/1-0.75 = 4

If m = 0.25, what will be the multiplier in open economyFm = 1/1-b+m Fm = 1/1-0.75+0.25 = 2 This is reduced because rising demand is being challenged off into the purchase of imports.

Example

Y= C+I+G+(X-M) C = 100+0.75Yd
I = 50, G = 50, X=10, M+m =5+0.1Y, and T = 50

SolutionY=100+ 0.75 (Y-50) + 50 + 50 +10 -5-0.1Y = (1-0.75+0.1)Y = 100-0.75x50+105 =167.50 167.5/0.35 = 478.57

Fm = 1/1-0.75+0.1 = 1/0.35 = 2.86