Q 1 .

M U LTIPLIER

M u l tipl ier coef f i ci ent ref e rs to the mu l ti pel i n c rea se s ni the e qu il i bri u m l evel
of ni come ca u s e d by a cha n ge n i the l evel of a ggr e ga te spe ndin g . The
i n vestmen t pa rt of the tota l spe n d in g i s d etermni e d by the market me cha n ism
a n d is a re l a ti vel y more d yn ami c d ete r mi n an t of ou tpu t , e mpl oymen t a nd
ni come . The va l u e of the mu l tipl i er si main l y dete rmi n ed by the va u l e of
ma rgi n a l propen si ty to c on sume .

S pe n dni g creates i n c ome . It l e a d s to a r si e ni i n come of those prod u cers

on w hose good s a n d s ervic es the spe n d ni g si made . The spen d i n g may
be on c a pi ta l good s (c al l ed i n ve stme n t ) , on in puts , an d on consu mpti on .
( It i s a s su me d tha t there is n o govern men t e xpe ndi tu re a n d there a re n o
n et e x por ts ) . If the s pen d i n g i s d on e ou t of the i n crea sed i n come wi thou t
an y decre a s e i n the e xsi ti n g n i come of the soc i ety , i t ha s on e i m pa ct on
ni c ome cr e a ti on . If the spen d i n g i s d on e ou t of the i n c rea sed
i ncome of on e se cti on of the soc ei ty ob tai n e d by reduci n g the i n c ome of
a n other s ecti on of the socei ty , there is a n other i mpa ct .

E xa mpl e : Su ppose the govern me n t c ol l ects in come by w ay of tax a n d

spen ds on peopl e ther e ma y n ot be a n y n et i ncrea se i n i ncome . Thi s
si becau se ta x e s r edu c e i n c ome of the peopl e w hi c h ma y l ea d to
re du ced s pen d ni g by the pe opl e .

W O RKING
Suppose I 100 a n d MPC 0 . 8 . In ve stment mea ns s pen ding on capi ta l
g oods . Thsi r a i ses ni c om e of the se l l e r s of c a pi ta l g ood s by 100 . Thi s
i s f i r st r ou n d in cr ea se in Y . Sin ce M P C =0 . 8 , 80 % of the f i rs t roun d
i n cr ea s e i n Y si spen t on C , i . e . 80 . Thi s ra i ses i n come of su ppl i e r s of
con su mers g ood s by 80 . Thi s i s secon d rou n d in crea se i n Y . Si mi l a rl y , the
third rou nd in cre a se i n Y si 80 % of the sec on d rou n d , i . e . 64 . The i n -
come
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 g oe s on i nc r ea sni g roun d a fter roun d . The su m of a ll su ch i n creases i s
5 00 , i . e . 5 ti mes the I . Note tha t gi ven MP C = 0 . 8 , MP S = 0 . 2 , w ith
ni crease ni Y , sa vi ng ( S ) a l so ni c rea ses by 20 % . Sa vi ng mean s ‘ n ot
spen di n g ’ . Whe n the su m total of n i cre a ses in S becomes 100 , i n cre a se i n
Y stops .

R ou n d C ha n g e C ha n g e in C C ha nge
in Y ni S
1 100 80 ( =100x0 . 8 ) 20
2 80 64 ( =80x0 . 8 ) 16
64 5 1 . 2 ( = 64x 0 . 8 ) 12 .8
51 . 2 40 . 96 ( =51 . 2x0 . 8 ) 10 . 24

Tota l 204 .8 163 . 84 40 . 96

Fin a l 5 00 400 ( =5 00x0 . 8 ) 100

DER IVATIO N
The s i ze of the mu l tipl ei r d e pen d s upon MPC . A l arge M PC mea n s a
l a rg e i ncrea s e in con su mpti on spen di n g , a l a rg e i n c r ea s e i n i n come a n d ,
ther ef ore , a l a rge mu l tpi l ei r . The proce s s of in crea se i n i n c ome ni i ti a ted by
the cha n ge in i n ve stmen t reache s n ew equ i l i br iu m when cha n ge in i nvestme nt
be comes equ a l to cha n ge n i savi ng .

Δ Y = Δ I / 1 - mpc
Δ Y / Δ I = 1 / 1 - mpc

Δ Y / Δ I = mea su re size of the mu l tpi l i er

Thus , measu re size of the mu l tipl i e r = 1 / 1 -mpc

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A LGE BR AIC DE R IVA TION :

Y = C +
So , Δ Y = Δ C + Δ I

C = a + bY ( 2 )

Su bs ti tuti n g 1 a n d 2 ,

Δ C = bΔY
Δ Y = bΔY + Δ
Δ Y - bΔY = Δ
Δ Y (1 -b ) = ΔI
Or ΔY = (1 / 1 - b ) / Δ I
Δ Y / Δ I = 1 / 1 –b

A s b stands f or margin a l prope nsi ty to con su me

Δ Y / Δ I = 1 / 1 – MPC = 1 / M PS

LEAKA G E S / LIM ITATIO NS

1 . Sa vi ng con sti tu tes a l ea kage : the hgi her the sa vni g , the lesser w ou l d b e
the mu l tpi l ei r .
2 . If a pa rt of the in cr ea sed income i s u se d for repa y men t of debt then
the val ue of the mu l ti pl ie r woul d b e red u ced .
3 . Hol d in g of idl e ca sh w li l re d uce the va l u e of the mu ltipl ier .
4 . Pu rcha se of ol d s tocks a n d se cu ri ties .
5 . Import .
6 . If the el a sti ci ty of suppl y i s l ow , then an ni crea s e in i n come ma y l ead to
on l y a pri ce in cre ase.
7 . Ta xa toi n red u ces MPC . Theref ore , the val u e of K is red u ced .

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 ASSUM PTIO NS
1. The ma r gi n a l pr ope n sity to con su me is con stan t .
2. There i s a c l ose d econ omy u n a f f e cte d by for ei g n i n flu en ces .
3. Con su mpti on i s a f u nc toi n of cu rr ent n i come .
4. There are no ti me l ags ni the mu l ti pl ei r pr ocess .
5. Ther e ar e n o c han g es i n pri ces .
6 . The e con omci situ ation shou l d b e l ess tha n fu l l empl oymen t l evel . If
there i s al rea d y fu l empl oymen t , MP C wil n ot be ef fecti ve.
7 . The n ew l eve l of in vestmen t i s ma i n ta i n ed s teadil y for the compl e toi n of the
mu ltipl i e r pr oc ess .
8 . C on su mer goods are a va li abl e i n respon s e to e f f e c ti ve d ema n d f or them .
9 . O the r resour ce s of prod u ction are al so e a si l y avali a bl e w ti hi n the econ omy .
10 . There i s n et i n crease i n investment

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 Q 2 . NE T EXPOR T FUNC TION

N et export si the di ff eren c e b e tween exports a n d i mports . Expor t f u n ctoi n si

au ton omou s as i t de pen d s upon spen din g de c i si ons ma d e by fore i gn con -
su mers or oversea s f ri ms tha t pu rc hase d omes ti c good s a n d s e rvi ces ,
a n d thus d o n ot cha n ge wi th cha nge ni domestic level of n i come .
Exports a r e dete rmi n ed by i n f l u e n ces outside of the home econ omy so this i s
a uton omou s spe nd i ng from the poni t of vei w of the d ete rmin ati on of
d omestci G DP . Export f u n cti on i s shown as a hor izon ta l stra i ght l i n e w ti h
refe ren ce to rea l G DP .

Net E xports = Va lu e of Exports – Va lue of Impor ts

The n et export va r i a bl e i s very impor ta n t i n the compu tati on of a cou n tr y ’ s

G DP . A tra d e su rplu s is added to the cou n try ’ s GDP . Net exports can a l s o
serve as a me a su re of fi n an ci a l hea l th for a c ou n try . A cou n try w i th a
high export val u e ge nera tes i n c ome fr om othe r c ou ntri es . It re ni forces the
f i n a n c i a l sta n d i n g of tha t cou n tr y , a s the i n f l ow of mon ey g i ves it the
opportu n ity to tr ade w ti h other c ou n tri e s .
A posi ti ve n et e xport fi gu r e show s a cou n tr y ’ s tra de s u rpl u s . It mea n s
tha t the va l ue of the n a ti on ’ s imports is l ow er tha n the va l ue of i ts
e xports . A cou n tr y w i th a trade surpl u s re cei ves more money f rom a f oreign
market tha n i t spen ds .
A n ega ti ve n et e xport f gi u r e is a tra d e defci i t f or a gi ven cou ntry . It m e a n s
that the over a l l val u e of the coun tr y ’ s m i ports si g rea ter than the overa l l
va l u e of ti s expor ts . A c ountr y w ith a tr a de deficit spen d s more mon ey in
a forei gn ma rke t than i t ma kes .

Fa ctors c a u si n g s hif ts i n Net E xpor t Func tion s other tha n R ea l G DP are ,

1 . F oregi n re a l n ati on a l ni come : An y c ha n ge i n real na tiona l i n come of the
f or ei g n cou n tries d ri e ctl y af fe cts the n e t expor ts of d ome sti c econ omy a s
w he n f oregi n GD P i n crea s es , foreig n d ema n d for good s i ncre a se s due to
w hi ch e xpor ts of dome sti c econ omy i n c rea ses . Thsi l e a d to pa ral e l l u pwa rd shif t
i n ne t export fu n cti on a s s ame a d d i tiona l a mou n t si sol d a t eac h l e vel of

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 d omesti c GD P .
2 . Rel a ti ve Intern a ti on a l Pri ce L evel : R el ati ve pri ce s of domesti c goods a n d se rvi ces
d e te rmin e competi tiven ess of the domestic econ omy . Cha n ges i n i n tern a toi n al
pr ci e l e ve l i n rel a toi n to the d omestci pri ce l evel wi l l be the re beca use of
tw o rea son s In fl a toi n r a te a nd Exc ha n g e ra te , cau s e n e t expor t fu ncti on
to shfi t . It a ffec ts both X an d M of the dome sti c e conomy .
3 . Excha nge rate : It si the ra te a t whic h c u r re n cy of one cou n try i s
e xc han ged f or cu rr e n c y of other c ou n tr y . In the f l exi bl e excha n ge ra te
syste m , exc ha n ge r ate fl u ctu a tes be cau se of c ha n g e in d e ma n d a n d
s u ppl y of cu r r en cies . Thi s f l u ctu ati on in excha n g e r ate affects the n et
e xpor t f u nctoi n of a n econ omy l i ke a n apprec i atoi n of the va l u e of
home cu rren cy in terms of f or eign c u rr en c y mea n s for ei gn deman d f or
domestic curren cy i s more than its suppl y . It ma kes domesti c good s costl i er ni
c ompa ri son to foreign good s w hi c h in tu rn l ea ds to re du c ed e x por ts a nd
i n c rea ses the i mports of the domestic e con omy w hi ch ultima tel y r edu ce s its
n e t export .

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 Q 3 . PAR A DO X O F THR IFT

The P ara dox of Thr fi t i s the the ory that in c rea sed savi n gs in the shor t
term can r e duce sa vni gs , or ra ther the a bi lti y to s a ve , in the l on g ter m . The
P a rad ox of Thri ft arsi es ou t of the Keyn e si a n n otoi n of a n a ggre ga te
dema n d - driven econ omy .
A n i ncrea se n i the r ate of s a vin g redu ces con su mptoi n i n the e c on omy
whi ch , in tu rn , red u ces total ou tpu t ( vi a Keyne sia n con su mpti on ) . Accordni g
to Bri ti sh econ omi st J ohn M a yn a rd K eynes , w hen peopl e save du ri n g a
reces si on , the l evel of consu me r spen di n g decre a ses , w hci h e ven tua l l y
sl ow s d ow n econ omic g rowth .

Sni c e sta r t of hu ma n cvi il i satoi n , i t was con si d e re d a vri tu e to keep

con su mption l e vel a t the mi n i mu m b u t the lasti n g ef f ects a n d c ha i n
rea cti on s of keepi n g con su mpti on i n check w e r e n ot real i sed . Pe opl e w e re
ta u ght tha t thri f t or savi n g s a re good b ec a u se a pe n n y saved tod a y w i l l
b ri n g i n cr ea s e d i n come .
In thi s con n e c tion , K eynes poin ted ou t ‘ pa r ad ox of thri ft ’ an d showed tha t
a s peopl e bec ome thrif tier , they en d u p savi ng l ess or sa me a s bef ore . If
a l l the peopl e of a n econ omy i n c rease the propor ti on of i n c ome whci h
i s sa ved (i . e . , MPS ) , the va l u e of sa vi n gs i n the econ omy w i l l n ot
i n cr e a se , rather i t wi l l d e cl i n e or remain u n cha nged .

C RITICISM
The Pa ra dox of Thri ft , w hi l e practci a l in i ts r e as on i n g , a ttra cted n u mer ous c ri -
tci isms f rom .
The n eo - cl a s si cal e con omi sts a r gu e tha t a con sumer s a vi ng si vi ew ed by the
ma rke t a s a sig n a l of su ppl y - si d e in ef f ci ienc y . A cons u mer savin g sen ds
the sgi n a l tha t the con s u me r DOE S NOT WAN T to con su me an y of
the good s i n the mar ket at the pr eva li in g ma rke t pr i ce .
There f ore , producers s hou l d either l ow e r the pri ce or c ha nge the good s an d
se r vi c es bein g produ ced . Thu s , the a c toi n of n ot con su mi n g does n ot
r e d uce f u tu re ou tpu t bu t merel y forc es the market to optimi ze .
Un der stan dard n eo -cl a ssi ca l e con omi c growth theory , sa vi n g i s es s en ti a l

7
 to e conomi c grow th a n d tec hnol og i ca l in n ovation . Most modern the or ies of
in n ova ti on a rgue tha t a thr es hol d l eve l of capi tal n e e d s to be re ached be fore
i n novati on ca n occu r . Technol ogi ca l i nnova ti on ca n si g n ifi can tyl ra i se the tota l
a mou n t of ou tpu t i n a n ec on omy .

In the gi ven diagram , in i tia l sa vi n g cu rve si SS a nd i n vestmen t c u rve si

II . E con omy atta i n s e qu il i brui m ( Sa vni g = In ve s tment ) a t E a n d equ li i briu m
l e ve l of i ncome is OY . Now , su ppose the society dec ides to be come thri f ty by
r e d u ci ng con su mpti on expen ditu re a nd In cre a ses s a vi n g by , sa y , A E .
As a resu l t , savin g cu rve shif ts u pwa rd to S 1Ss1 i n ter se cti n g In ve stmen t
curve II a t E 1 . U nplann ed i n ven tories will i n crea se a n d fi rms w i l l c u t
d ow n produ ctoi n a n d e mpl oyment a n d move to n ew e qu i l ibr i u m E1 . The
f igu r e show s tha t i n the en d , pl a n ned s a vin g ha s fal l en f rom AY to
E1Y 1 . Notice at n ew poi n t of e qui l ibrium E 1 , i nve s tmen t l evel a nd a l s o
re a l ise d sa vin g re ma i n the sa me ( E 1Y1 ) bu t l evel of i n come ha s f a l l en
f r om O Y to OY 1 . The decl i ne i n e qu i l bi r i u m l e vel of in come show s the
pa ra dox of thri f t as the revers e pr oc e ss of mul ti pli e r has w or ked on
redu c in g con su mpti on expen di tu r e . In f a ct Inc r e a sed sa vi n g i s vi r tu a l l y a
w ithdraw a l f r om c i rcu l ar fl ow of i n c ome .