Multiplier and Accelerator

THE MULTIPLIER:

In the following multiplier equation, the relationship between income and

investment is determined through marginal propensity to consume:

------------------------------------(ii)

Where:

(mps: Marginal Propensity to Save)

Therefore, the third multiplier equation is:

--------------------------------------(iii)

It should be noted that the size of multiplier varies directly with the size of
mpc. When the mpc is high, the multiplier is high and when the mpc is low,
the multiplier is also low.

The multiplier works not only in money terms but also in real terms. In other
words, the increase in income takes place not only in the form of money but in
the form of goods and services.
Example 1:

mpc is ¾

Initial investment is Rs. 1,000 million

Required:
 (a) Multiplier,

(b) Marginal propensity to save,

(c) Increase in the level of national income, and

(d) Conclusion.

Solution:

(a) Multiplier (K):

(b) Marginal Propensity to Save (mps):

(c) Increase in the level of NI:

(d) Conclusion:

From the above example, we can see that with an initial primary investment of
Rs. 1,000 million, with an mpc at ¾ and multiplier at 4, gives rise to an increase
of Rs. 4,000 million in the level of national income.

Example 2:
Calculate mpc, mps and multiplier (K):

mps K
mpc
4/6 ? ?
½ ? ?
? ¼ 4
? 1/7 ?
1 ? ?
0 ? ?

Solution:

*
If the mpc is 1, the mps will be zero and the multiplier will be infinity; and a given dose of
 investment (let say, Rs. 1,000 million) will automatically create full employment.

**
If the mpc is 0, the mps will be 1 and the multiplier will be 1 so that total increase in income
will just equal the increase in primary investment.

Keynes multiplier theory is also very helpful in the determination of national

income. In his book, ‘General Theory of Employment, Interest and Money’, he
has contradicted the viewpoint of the classical economists. He is of the
opinion that if an economy operates at a level of equilibrium it is not necessary
that there should be a high level of employment in a country. It is just possible
that there may be millions of people unemployed. So according to Keynes, if
any country wishes to achieve level of employment, it can only do so through
the changes in the magnitude of investment.

According to Keynes’ theory, there are two main methods of measuring the
equilibrium level of NI, i.e.:

(a) The AD-AS Approach, and

(b) The Saving Investment Approach

(a) AD-AS Approach: For explaining the determination of level of

income in a two-sector economy, we assume an economy in which
there is no international trade, no government role and in which
corporations retain no earnings. In this simplest model of economy, the
level of income is determined at a point where the AD intersects the
AS. It is depicted as below:
In the above diagram, the national income is determined at the point
where AD curve (C+I) cuts the AS curve (C+S), i.e., at E. The multiplier
effect is also shown in this diagram. The curve C represents the mpc
which is assumed to be ½. That is why the slope of curve C is
0.5. Since the AD curve (C + I) cuts the 45o angle line at E, OY1 is the
level of income determined. If now investment is increased to EH (ΔI)
we can find out the increase in income (ΔY). As a result of investment
EH, the AD curve shifts upwards to C + I’. This new AD curve cuts the
AS curve (45o angle line) at F, so that OY2 income is determined. Thus,
income increases by Y1Y2 as a result of investment increase of EH,
which (Y1Y2) is double of EH.

It is clear, therefore, that the multiplier is 2. It is also calculated as

below:

(a) Saving-Investment Approach: In order to simplify the analysis of

income determination we imagine an economy (1) where there are no
taxes levied by the government, (2) the corporations retain no earnings,
and (3) there are no changes in the level of prices. The equilibrium
level of NI is determined at a point where planned or intended saving is
equal to planned or intended investment, or in other words, where the
saving intersect the investment. It is further explained with the help of
following diagram:
 The above diagram shows the multiplier effect of an increase in
investment on the equilibrium level of income. SS is the supply curve
and II is the investment curve showing the total level of investment of
OI. These two curves intersect each other at the equilibrium point E
where is income is OY1. If now there is a change in investment from OI
to OI’, i.e., an increase of II’, then the II curve will shift to the position of
I’I’ and the two curves I’I’ and SS intersect each other at the new
equilibrium point E’, where the income is OY2. Now it is clear that when
mps is ½, an increase in investment by II’ (let say Rs. 10 million) has led
to the increase in income by Y1Y2 (let say Rs. 30 million). Obviously the
value of the multiplier is equal to 3.

Limitations of Multiplier:

(a) Efficiency of production: If the production system of the country

cannot cope with increased demand for consumption goods and make
them readily available, the incomes generated will not be spent as
visualised. As a result, the mpc may decline.

(b) Regular investment: The value of the multiplier will also depend on
regularly repeated investments. A steadily increasing investment is
essential to maintain the tempo of economic activity.

(c) Multiplier period: Successive doses of investment must be injected

at suitable intervals if the multiplier effect is not to be lost.
 (d) Full employment ceiling: As soon as full employment of the idle
resources is achieved, further beneficial effect of the multiplier will
practically cease.

Leakages of Income Stream and Their Effect on the Multiplier:

As we know that as income increases, consumption does not increase to the

same extent or proportionately, because a part of the income is saved. The
part of the income that is saved is as if a leakage from the flow of income
stream. These leakages obstruct the growth of national income. In the
absence of these leakages, mpc would have been unity. The consumption
expenditure would have increased 100 per cent of the increase in income and
there would have been full employment. The following are the principal
leakages:

(a) Paying off debts: It generally happens that a person has to pay a
debt to a bank or to another person. A part of his income goes out in
repaying such debts and is not utilised either in consumption or in
productive activity. Income used to pay off debts disappears from the
income stream. If, however, the creditor uses this amount in buying
consumer goods or in some productive activity, then this sum will
generate some income, otherwise not.

(b) Idle cash balances: It is well known that people keep with them
ready cash which is neither used productively nor in purchasing
consumer goods. Keynes has mentioned three motives for holding
ready cash for liquidity preference, viz., transactions motive,
precautionary motive and speculative motive. This means that the re-
spent part of income goes on decreasing. In this way, a part of the
initial expenditure leaks out of the income stream.

(c) Imports: The part of the money spent by country for importing
goods also leaks out of the country’s income stream. It does not
encourage or support any business or industry in the country. This is
specially so if the imports do not help the trade and industry of the
country or if they are not used for export promotion. The net import is a
leakage.

(d) Purchase of existing securities: Some people purchase securities

(saving certificates) from others and the seller of securities can hoard
this money. This money also leaks out of the income stream. This may
also be valid in case of purchase of shares, debentures, bonds,
 insurance policy, or some other financial investment. If this invested
money is not used in productive areas, there will be a leakage in the
income stream.

(e) Price inflation: Inflationary situation is also responsible for

leakage. In such a situation, investment does not help in generating
employment or increasing income. If there is already full employment in
the country, increase in investment, far from increasing demand for
consumer goods, it decreases it as a result of which employment in the
consumer goods industries contracts and demand for capital goods
decreases. Whatever increase in income there is, it is spent in high
prices and it does not help in creating income and employment.

Importance of Multiplier:

Keynes’ principle of multiplier has a great role in removing the Great

Depression of 1929-34. These days governments are actively interfere in the
economic affairs of the community through multiplier. Its importance is further
explained as below:

1. The multiplier principle focuses on the importance of public

investment, which is the key to remove unemployment during the days
of depression. An investment of Rs. 1 million can create income and
employment worth many times, and can help the government to remove
unemployment from the country.

2. During the days of depression, the private entrepreneurs are

discouraged to invest in the economy. Therefore, to fill this gap, the
government comes forward and undertakes the investment in her
own hands. Hence, the demand for consumer goods increases and
also the level of NI and employment increases on account of the
working of the multiplier.

3. When the demand for goods increases and incomes rise owing to
government investment, the profit expectations of the entrepreneurs
go up and as a result the MEC rises.

4. When the government makes investment in public works to fight

depression and unemployment, private investment is encouraged on
account of the operation of the multiplier. The confidence of private
investors is restored, and hence helps in further removing the economic
depression of the country.
Assumptions of Multiplier:

The following certain essential conditions / assumptions for the operation of

multiplier:

1. The supply curve of output should be elastic. In other words, when

demand for certain goods or services increases, its supply can be
increased without much difficulty.

2. There is excess productive capacity in consumer goods industries,

so that the supply of goods can be easily increased when demand
increases.

3. The supply of raw materials and working capital should also be

elastic.

4. There should be ‘involuntary unemployment’. That is, there are

people who want work at the prevailing wage rate, but are not getting it.

Criticism on Keynes’ Multiplier Theory:

Many economists including the classical economists and the economists from
third world countries have strongly criticise the Keynes’ Multiplier Theory. It is
explained in brief as below:

1. Keynes’ multiplier theory assumes that the supply of output, raw

materials and working capital is elastic, i.e., it can be increased
whenever required. But, according to critics, this condition cannot be
fulfilled in an under-developed country (UDC), where there is a
continuous vicious cycle of poverty. The whole economy is based on
agriculture, and there is a dearth of capital equipment, skill labour and
technology. The existing industries cannot fulfill the increased
demand. Moreover, the government is so poor to invest in public
works.

2. According to Keynes’ multiplier theory, there is excess productive

capacity in consumer goods industries. But according to critics, there
is a little excess productive capacity in poor countries; therefore,
this theory cannot be applied to UDCs.

3. Another condition of Keynes’ theory is that there should be ‘involuntary

unemployment’. That is, there are people who want work at the
 prevailing wage rate, but are not getting it. Whereas, in UDCs, there is
‘disguised unemployment’, and most of the workers are self-
employed, therefore, this condition cannot be fulfilled in such countries.

4. According to critics, this theory can only be applied to economically

advanced and highly industrialised countries, and cannot be
applied to under-developed countries, which are pre-dominantly
agricultural countries. In UDCs, the heavy plant and machineries, and
skilled labour are not easily available and the supply cannot be
increased quickly.

THE ACCELERATOR:

According the principle of accelerator, when income increases, people’s

spending power increases; their consumption increases and consequently the
demand for consumer goods increases. In order to meet this enhanced
demand, investment must increase to raise the productive capacity of the
community. Initially, however, the increased demand will be met by over-
working the existing plants and machinery. All this leads to increase in profits
which will induce entrepreneurs to expand their plants by increasing their
investments. Thus a rise in income leads to a further induced
investment. The accelerator is the numerical value of the relation between an
increase in income and the resulting increase in investment.

Assumptions of the Accelerator:

1. Under the principle of accelerator, it is assumed that there is no

excess capacity existing in the consumer goods industries. No
machines are lying idle and shift working is not possible.

2. In capital goods industries, it has been assumed that there is an

existence of surplus capacity. If there is no excess capacity in
capital goods industries, increased demand for machines could not lead
to increase in the supply of machines.

3. Output is flexible. The machine-making industry or capital goods

industry can increase its output whenever desired.

4. The size of the accelerator does not remain constant over time. It
value will be affected by the businessmen’s calculations regarding the
profitability of installing new plants to make more machines on the basis
of their probable working life.
5. The demand for machines will remain stable in the future, although
the increase in demand has suddenly cropped up.