You are on page 1of 30

The Theory of Multiplier and


Concept of the Multiplier
• With the increase in the level of Aggregate
Level of Spending, there is an expansion of
income & output in the economy
• The income & output would increase by a
multiple of aggregate spending. This multiple
is known as multiplier
• Earlier this concept was introduced by Kahn
as Employment Multiplier
• Later on Keynes had introduced the concept
of Investment Multiplier

Types & Features
• Investment multiplier
• Government Expenditure multiplier
• Tax Multiplier
• Transfer Payments Multiplier
• Foreign Trade Multiplier
• Balanced Budget Multiplier
• Difference in Static & Dynamic Multipliers

Static Multiplier
• From the point of view of the static
framework, if investment increases then by
what multiple of investment does income
• Static multiplier means that any change in
investment expenditure is assumed to have
instantaneous impact on income and hence
• In static equilibrium, Y=C+I+G
• So ΔY/ ΔI=1/(1-c), where c=mpc
• Thus, ΔY/ ΔI=1/s, where s=mps 4
Static Multiplier
• In static equilibrium, Y=C+I+G
• Or Y= C0 + C1Y + I + G,
• ΔY= C1 Δ Y + Δ I
• (1- C1) ΔY = Δ I
• ΔY/ΔI= 1/(1- C1)
• So ΔY/ΔI= 1/(1-C1), where C1=mpc
• Thus, ΔY/ΔI=1/ S1, where S1=mps

Assumptions of Multiplier Theory
• MPC remains constant

• Time lag has been ignored in the model

• Existence of excess capacity in the consumer

goods industry
• Therefore, prices are assumed to be constant.
i.e. there is no rise in price owing to increase in

Leakages in Multiplier Process

• Paying off debts

• Holding of idle cash balances
• Imports
• Taxation
• Increase in Prices

Numerical Problem on Multiplier
• Suppose the level of investment is in an economy
is Rs 200 crore and consumption function of the
economy is:
• C = 80 +0.75Y
• What will be the equilibrium level of income?
• What will be the increase in income if investment
increases by Rs 25 crore?
• Solution: Equilibrium income:
• Y=C+I
• Y = 80 +0.75Y + 200
• Y = 280 +0.75Y
Numerical Problem on Multiplier
• (1- 0.75) Y = 280 or (1- 3/4) Y = 280
• 0.25Y = 280 or 1/4 Y = 280
• Y = 280/0.25 = or 280*4= 1120 crores.
• If investment increases by then by how
much income will increase will depend on
the size of the multiplier
• Multiplier = 1/(1-MPC) = 1/(1-0.75) = 4.
• So for 25 crore increase in investment,
income will go up 4 times to Rs. 100 crore
Paradox of Thrift

• Multiplier = 1/s, mps=s


O Y2 Y1 National Income
The Business cycle is the rise and fall of economic activity
relative to the long-term growth trend of the economy

The peaking out




The boom

The upturn The recession

Concept of business/trade cycle
• According to J.M.Keynes ‘A trade cycle is
composed of periods of good trade characterised
by rising prices & low unemployment percentages
with periods of bad trade characterised by falling
prices & high unemployment rate.’
• Business cycles are recurrent but irregular
fluctuations in economic activity & occurs one after
• The time span of the period & phases may vary

Phases of Business Cycles
• Expansion (Boom, Upswing or Prosperity)
• Peak (Upper Turning Point, when economic
activity begins to slow down)
• Contraction (Downswing, Recession or
• Trough (Lower Turning Point, when
economic activity begins to rise)

Features of Business Cycles
• Business cycles are irregular in nature
• Fluctuations occur in a number of other variables
simultaneously apart from production
• Investment & Consumption of durable goods are
more affected
• Investment & Consumption of non durable goods
are much less affected
• Immediate effect on the level of inventory stock
• Profits fluctuate more than any other incomes

Investment Function and Accelerator
• Till now we have seen the concept of the
multiplier, which says that when investment
increases by a certain amount,
income/output increases by a multiple of
• The acceleration principle defines exactly
the opposite, and it says when income or
consumption increase by a certain amount,
investment rises by a multiple of that. This is
known as induced investment.
Investment Function and Accelerator
• The accelerator is the numerical value of the
relation between the increase in investment
arising out of increase in income.
• As is understandable, to produce a given
amount of output, it requires a certain amount of
capital. If Y is the given income at t time period,
then the amount of capital required to produce
this output would depend on the capital-output
ratio (COR), w. Mathematically, the relation is as
given below:
• Kt = w. Yt, so this COR w is equal to K/Y.

Investment Function and Accelerator
The accelerator is assumed to be constant and
greater than 1. Therefore, changes in output are
made possible by changes in the amount (stock) of
capital. Addition to capital stock over time is known
as Investment.
So when income increases from Yt to Yt+1 , capital
stock will also increase from Kt to Kt+1.
Or Kt – Kt-1 = w (Yt – Yt-1 ) = w ∆Yt
Since Kt – Kt-1 = ∆ Kt = It,
It = w ∆Yt, where
Incremental capital/output ratio (ICOR)= ∆ Kt/∆Yt
This relationship is known as accelerator principle.
The capital/output ratio w is known as the accelerator.
Features of the Accelerator
• It = w ∆Yt,
• The equation or the accelerator principle says that
investment is a function of change in income.
• If income and output remains same over time, i.e. Yt = Yt-
1, then investment will be zero.

• Only if income and output increases over time, i.e. Yt >

Yt-1 , then investment will be positive
• If income and output decrease over time, i.e. Yt < Yt-1 ,
then investment will be negative or there will be
• This along with the multiplier explain business cycles, the
booms, the downturn, recession and finally the upturn.

Working of the Business Cycle
Increase in Increase in
investment Income through

Increase in Induced Investment

through Accelerator

Income and Aggregate

demand change by an even
larger amount
Working of the Business Cycle
If income Decrease in Induced
goes down investment through
in the next Accelerator

Decrease in income
through Multiplier

Consumption demand and

Aggregate demand decrease
by an even larger amount
Accelerator-Multiplier Interaction
• Fluctuations in investment are the main
cause of instability in free-enterprise
economy. According to the accelerator
principle, even if the growth of economy
slows down, it can result in negative
investment. Any change in components of
aggregate demand will produce a multiplied
effect, depending on the value of the
multiplier (or MPC). This change in
consumption, income will induce further
change in investment and the extent of
change would depend on the accelerator.
Numerical on Incremental Capital
Output Ratio (ICOR)
Question: Given average real GDP growth rate
of 9% and average investment ratio of 36%,
estimate ICOR. Assuming that ICOR declines
by 5% due to increase of productivity, how
much investment is required if we plan for a
growth of 10% per annum?
Answer: ICOR = 36/9 =4.
If ICOR declines by 5%, then 5%*4 = 0.2
New ICOR = 3.8
So required investment for a growth rate of 10%
= 3.8 * 10 = 38%.

Causes of Business Cycles
• There are many theories suggesting
explanations for business cycles.
• Climatic changes
Under consumption
Over Investment
Keynes’ theory of effective demand,
particularly investment

Causes of Business Cycles
• Booms/recessions can be generated by rise/fall in
government expenditure, fiscal policy.
• Similarly, a wave of optimism/pessimism can
cause consumers to spend more/less than usual.
• Similarly, firms may invest more (build up new
• Another possible cause of recessions and booms
is monetary policy.
• A firm faced with high interest rates may decide to
postpone building a new factory.
• Households may be lured by cheap housing
loans, and construction activities may boom.
Movements of Certain Macro economic
variables during Business Cycles
Variables can be classified as procyclical,
countercyclical or acyclical, depending on the
direction of change.
• Procyclical- Variables have positive correlation.
They usually increase during booms and decrease
during recessions. Consumption, investment and
employment are strongly procyclical. Construction,
finance, retail also are procyclical.
• Countercyclical- Variables have negative
correlation. Unemployment is countercyclical.
• Acyclical- Variables have zero correlation,
implying no systematic relationship to the
business cycle . capital stock is acyclical.

Cyclical behavior of macro economic
variables according to time of
Variables can be classified as leading,
coincident or lagging variable.
Leading Indicator: which occurs ahead of the
occurrence of business circle variable.
Coincident Indicator: which move up and down
along with the business cycle variable.
Lagging Indicator: which follow the business
cycle variable after some time lag.
Leading Indicators
– housing starts;
– New orders for plant and equipment
– stock prices;
– demand for consumer durables;
– consumer expectations;
– New employment;
– Deliveries by Companies;
– Index of consumer confidence;
– Index of business confidence;
– Money growth rate (M2)
Coincident Indicators

• Nonagricultural employment
• Index of industrial production
• Personal income
• Manufacturing and trade sales

Lagging Indicators

• Wage rates
• Rate of inflation
• Consumer credits
• Lending rates
• Outstanding loans

Cross Classification of Indicators
Items Direction of Time of
change occurrence
Industrial output procyclical coincident
Capacity utilization procyclical coincident
Employment procyclical coincident
Unemployment countercyclical coincident
Inflation rate procyclical lagging
Corporate profits procyclical coincident
Short-term interest procyclical lagging
Share price procyclical Leading
Capital stock acyclical lagging