Transcript Leakages of Multiplier 1x

Leakages of Multiplier
• Increase in Income due to increase in initial
investment, does not go on endlessly.
• The process of income propagation slows down
and ultimately comes to halt. Causes responsible
for the decline in income are called leakages .
• In words of Peterson ,” income that is not spent
on currently produced consumption goods and
services may be regarded as having leaked out of
income steam .”
• The more powerful these leakages are ,the
smaller will be the value of multiplier.
Some important leakages
•
•
Idle saving :idle saving leads to equivalent fall in
marginal propensity to consume .it results into
fall in the value of multiplier. As a matter of fact
,higher the MPS greater is the leakage from
income propagation and smaller is the value of
multiplier.
Purchase of govt.: securities and shares : when
some part of increased income is used to
purchase old shares and govt. securities means
this part of income is not spent on consumer
goods . Consequently , the flow of income
stream falls.
• Paying of old debts :That part of increased
income which is utilised in paying of old debts is
obviously not spent on cosumption .This leakage
also constricts the process of income generation .
• Import: liquidity drains out of the system
equivalent to the value of imports through which
propensity to consume falls limiting the multiplier
effect of increased investment .
• Excess stock of consumption goods: increase in
income leads to increase in consumption .if the
increased demand for consumer goods is met out
of the existing stocks ,means new consumer
goods are not produced that results into
hampering the growth of multiplier.
• High liquidity Preference: it means if people want to
hold more money in cash for transaction,
precautionary and speculative motives, it would
imply less expenditure also serves as a leakage of
multiplier.
• Price Inflation: under inflationary situation people
have to spend more money to buy same amount of
goods and services as before. The effect is that there
will be not much increase in level of consumption and
ultimately multiplier effect will remain limited.
• Taxation system : if taxes on goods and progressive
taxes on income are increased ,there will be no
appreciable increase in consumption despite increase
in income . As a result process of income propagation
slows down .
• Undistributed profits of companies: Many
companies do not distribute all the profits among
the shareholders; as they keep a part of it as a
reserve fund. The undistributed profits also
serves as a leakage of the multiplier because this
amount is not made available to the shareholders
who could use it as a consumption expenditure.
Importance of Multiplier
• Income Propagation: concept of multiplier tells
us that income propagation is a natural process.
It tells that increase in employment, income and
output is due to increase in investment .
*Income is generated in an economy in much the
same way as a stone thrown in a lake causes
ripples .*
• Importance of Investment: it is the initial
increase in the investment that results in
multiple increase in income . As a matter of fact,
investment is that dynamic element on which
changes in employment depend.
• Trade Cycles: trade cycles are those cycles which tell
business fluctuations take place over a period of long
run. Sometimes there is a boom and at another time
there is depression in business. So multiplier helps in
understanding trade cycles .
• Full Employment: Multiplier’s concept is of great
importance while formulating policy regarding full
employment. it shows that to attain full
employment situation a thrust of net investment
should be made in the economy .
• Deficit Financing: deficit financing helps in removing
bad effects of depression. it is so because as a result
of deficit financing investment increases and
increase in investment causes multiple increase in
income in terms of multiplier effect.
• Equilibrium between Saving and Investment:
According to keynes theory of Employment ,
Equilibrium is established when Saving and Investment
are equal. Equilibrium between Saving and Investment
can be achieved through change in the level of
income. If saving is low in an economy, it can be
known from the concept of marginal propensity to
save how much increase in income is needed to get
the required increase in saving. And to increase the
level of income how much investment is needed, can
be determined from the co-efficient of multiplier.
• Public Investment: concept of multiplier testifies that
if during depression, a little increase in public
investment is made, it will lead to multiple increase in
income such an increase in income will help in
controlling depression and unemployment.
Multiplier and Public Investment
• Concept of multiplier propounded by John
Meynard Keynes lays emphasis on the significance
and utility of public investment .
• Public investment refers to govt. expenditure on
public works and public welfare activities.
Purpose of this investment is not to earn profit ,
as is the case with private investment. It is called
autonomous investment, because it is
independent of profit motive .
• Its objective is to increase employment and
stimulate business during a cute depression
Relationship between Multiplier and
Public investment
• There is a close relationship between multiplier
and public investment . Concept of multiplier
proves that if during depression public investment
is increased a little, it will lead to multiple
increase in income .
• With a view to realizing full-multiplier effect of
investment , the govt. should take care of the
following factors :
• Public investment should be made in those areas
where MPC i.e (marginal propensity to consume) is
maximum. MPC is more in underdeveloped and
backward regions.
• Public investment should be undertaken at a time
when multiplier effect is maximum. It is maximum
during boom and depression periods .
• It is essential for the working of multiplier that on
account of increase in Public investment, there
should be increase in the total investment in
country .
• Income that increases on account of Public
investment should not be concentrated in hands of
the rich class as its marginal propensity to consume
is low .
• As soon as economy attains full employment
situation, the public investment should be
slashed considerably. If it is not done, the
multiplier effect of public investment may give
rise to inflation in the economy.
• public investment should be so coordinated as to
get maximum multiplier effect. At the same time,
care should be taken to ensure that as soon as
signs of boom situation appear, the govt. should
slow down public investment or vice –versa .
• Tautological : it is a Tautological concept wherein the
same thing has been said repeatedly in different
words .it does not express anything new.
• Relation between Income and Consumption: the
assumption of multiplier that MPC is less than unity
and remains constant is wrong ; because, in fact,
Relationship between income and consumption is not
so simple as is assumed by keynes.
• Effect of Acceleration is Ignored: it does not take into
consideration, change in investment as a result of
change in consumption. In fact, multiplier is
influenced not only by investment but also by
consumption expenditure. if consumption
expenditure is increased, the multiplier will continue
to work, although no investment is undertaken.
• Unnecessary importance to Deficit Financing :
concept of multiplier has given Unnecessary
importance to Deficit Financing in preference to
many important and appropriate methods of
monetary policy.
• Practical Defects : the Practical defects of concept
of multiplier lies in the fact that it has made
investment a casual factor whereas, in reality,
investment is the effect of saving to a large extent.
• Complete Elasticity in the Supply of Funds and
Supply of Consumer’s Goods.
Types of Multiplier
Employment Multiplier
• The employment multiplier is the ratio of
increase in total employment to the increase in
primary or original employment .
Foreign Trade Multiplier
• The ratio of change in total income to change in
export income is called foreign trade multiplier.
Employment Multiplier
• This concept is related to increase in employment.
According t∆o R.F khan increase in investment will cause in
increase in employment not only in those very industries
where in such investment has been made but in other
industries also.
• Employment increases in two ways.
1) Primary Employment
2) Secondary Employment
• Employment Multiplier can be expressed by an equation as
follows.
K1=N2/N1
(Here k1=employment multiplier; N2= Total employment;
N1= Primary employment.)
Foreign Trade Multiplier
• When foreigners import goods from our country ,
domestic export industries earn revenue. Income of
those people who work in export industries will
increase. They will increase their consumption
expenditure.
• The effect of it will be that, income of those who
produce consumer goods will rise.
• In this way increase in export income, aggregate
income increases many times more.
• It can be expressed by an equation as follows.
Kf= ∆Y/ ∆E .
Working Of Multiplier in under
developed countries
Multiplier does not work in the same manner in
under developed countries as in developed
countries . According to keynes, in developed
economy an increase investment leads to
multiple increase in income because of the
multiplier effect. The increase in income
depends on MPC.
• No doubt, MPC is high in under developed
countries, the value of multiplier is low.
Reason for why
the value of
multiplier is low,
despite of high
degree of MPC
• Working of multiplier holds good when a part of an
increased income, as a result of increase in
investment, is spent in the second round. On account
of this expenditure in the second round there will be
a corresponding increase in income . In this way
income will go on rising. But ,
1. In underdeveloped countries ,when income
increases initially as a result of increase in
investment then this increased income when spent
in the market is not matched by the corresponding
flow of goods and services .
2. That is, in these economies increase in consumption
expenditure is not accompanied with increase in
production. Ultimately increase in consumption
expenditure is followed by rise in prices
1. Firstly, they will make more use of their
produce for self consumption it will cause
corresponding fall in the marketable surplus.
2. Secondly, they will increase their demand for
industrial goods, but the production capacity
of the firms producing industrial goods is also
limited . Hence despite increase in demand
for industrial goods their real output does
not increase ; rather prices begin to rise.
• Another reason being that: when income of the
people , in these economies increases it pushes
up the demand for food because of extreme
poverty.
• Increased demand for food and other agricultural
products leads to increase in the income if the
farmers. The increased income the farmers will
not cause any increase in investment because;
1. Supply of agricultural products is inelastic , and
2. In under developed countries there is a shortage
of resources for the development of agriculture .
• So, farmers will use their increased income in
two ways :
• According to Dr Rao, keynes concept of multiplier is based
on certain assumptions, such as :
1. Open employment
2. Industrialized economy
3. Excess capacity in consumption goods industries
4. Comparatively elastic supply of raw material and working
capital .
• All these assumptions are lacking in under developed
countries. In these countries there is disguised
unemployment instead of involuntary unemployment .
• Hence for want of assumptions of multiplier in under
developed countries this concept is not fully applicable to
them. In these countries since supply does not increase
immediately in response to increase in investment, prices
and not real income begin to rise.
Dynamic Concept Of Multiplier
• Keynes concept of multiplier is criticized as a
static concept. It is a static concept because it
simply tell how many times more increase in
income will be there as a result of given increase
in investment. However, this concept does not
reveal how and with what time-lag this increase
in income will take place. It simply tell about the
final conclusion. The modern economist study
multiplier in dynamic form it show the working of
multiplier.
Assumptions
The modern theory of the multiplier is based on
the following assumptions:
• The consumption of the current period
(c1)depends on the income of the previous
period (yt-1).
• There is time lag between investment and
income. On other words investment in period
t will increase income in period t+1. it means
Yt+1=(fIt).
Explanation
• The modern theory of dynamic multiplier can be
explained with the help of table and figure a and b. it
should be remembered that there is time lag between
change in investment and income. Whenever initial
investment is increased it takes lot of time to increase.
This increase in income is not immediate take place. In
this time lag, many other changes may take place.
• The dynamic concept of multiplier tell us how, from the
time of initial change in investment, the process of
multiplier moves on. The concept of multiplier proves
valid in the sense that
increase in aggregate demand=aggregate increase
in investment*marginal propensity to consume
• Table shows that as a result of initial increase in investment by
Rs 100 crore, there is change in income by Rs 100 crore.
Where MPC is .5. hence on account of increase income by Rs
100 crore. Consumption will increased by 50 crore and 50 will
be saved.
• Expenditure of one man is an income of another in an
economy. Hence due to expenditure of Rs 50 crore on
consumption. Their will be an increased of Rs 50 crore in
income on second time period. As a result of it, there will be
increased in consumption by 25 crore and Rs 25 crore will be
saved.
• On account of increase in consumption expenditure by Rs 25
crore, there will be increase in income by Rs 25 crore in next
time period.
• Thus, in different time period as shown in the table income
will go on increasing as a result of increase in consumption
expenditure. Ultimately income will increase to Rs 200 crore
multiplier(K) =
Diagrammatic Presentation
• The process of multiplier is expressed diagrammatically in
fig b. this diagram is drawn on the assumption that MPC=.5
and that consumption ‘t’ time depend upon income of ‘t-1’
time.
it means that the consumer does not spend his
income immediately on it’s receipt but he spents it after a
time period. there is time lag between income and
consumption expenditure.
• In the fig, income is shown on ox-axis and expenditure on oy-axis.
AS is aggregate supply curve drawn on 45*. AD is aggregate
demand curve supposing , the initial equilibrium at an income level
is Rs 100 crore. In this situation the entire income is consumed.
Point A is an equilibrium point. Because at this point, AD=AS.
Equilibrium point A is the initial point of multiplier process.
Supposing an investment of Rs 100 crore is initiated in the
economy. As a result of it aggregate demand curve will shift to AD1.
(c+i+ i)
• As a result of increase in investment by Rs 100 crore there will be
increase in income by Rs 100 crore in first round.
• In the second round consumer will spend Rs 50 crore on
consumption resulting in an increase in income by Rs 50 crore.
• In third round the consumer will spend Rs 25 crore on consumption.
As result, income will increase by 25 crore.
• This process will continue till additional consumption expenditure
becomes 0. this situation will arise at point E when the level of
income become Rs 300 crore. It thus proves that an investment of
Rs 100 crore ultimately leads to an increasing income by Rs 200
crore.
• In other word, if MPC is 2 then an increase in investment by Rs 100
crore will ultimately leads to increase in income by Rs 200 crore.
Dynamic multiplier and change in
investment
Process of dynamic multiplier depends on change in
investment. There may be two types of change in
investment;
1. Single injection of investment; if investment is
increased only once, it will result into change in
income only once, thereafter income will revert back
to its old level.
Supposing MPC=0.5 OR Multiplier is 2
An increase in investment by Rs.10 crore will cause
an increase in income by Rs.10 crore in that period.
Thereafter, as is shown in fig.
• In the first time period, income will increase
by Rs.5 crore.In the second time period,
income will increase by Rs. 2.5crore.
• In this way, after a few time period find effect
of increase in investment will fade away and
increase in income will fall to zero. Economy
will return to initial level of expenditure .
2. Continuous injection of investment; effect of
multiplier will be permanent if there is continous
injection of investment in the economy. It will enable
the income to move from its initial level to a new
level. Change due to continous injection of
investment.
The diagram is based on two assumption ;
a)An investment of Rs. 10 crore is made in each time period.
b) Marginal propensity to consume is 0.5.
To begin with, an investment of Rs. 10 crore will lead to an
increase in income by Rs.10crore. Out of this increased income Rs.5
crore will be spent on consumption, because MPC 0.5. in this way,
during the first time period, the total increase in income due to an
investment of Rs.10crore and consumption-expenditure of Rs. 5 crore
will be 15 crore.
• In 2nd time period, new investment will be Rs.10crore,consumptionexpenditure on account of increase in income in the first time period
will be Rs.5crore and consumption-expenditure on account of increase
in income, in the initial time period will be Rs. 2.5 crore.
Income in the different time period will go on increasing
till it reaches to Rs. 20crore. Which shows MPC=0.5 and hence
multiplier is 2.
Characteristics of Multiplier
• Aggregate Demand ; That is, the investment and consumption,
cause the multiplier effect. Economists generally associate
multiplier with change in investment. However, change in
consumption or government expenditure or exports can have the
same effect.
• It works in both directions, i.e., forward and backward.
• There is an inverse relationship between marginal propensity to
save and the size of the multiplier.
• Size of the multiplier depends upon the sixe of marginal propensity
to consume. Higher the marginal propensity to consume, greater
will be the sixe of multiplier.
• Sixe of multiplier is reduced proportionate to the leakages of the
current income flow.
• Multiplier effect can operate continously only if there are continous
and autonomous changes in expenditure in the economy.
Limitations of multiplier
•
•
•
•
•
•
•
•
•
Availability of consumer goods
Multiplier period
Less than full employment level
Steady flow of investment
Net incrase in expenditure
Net increase in investment
Autonomous investment
Closed Economy
Constant marginal propensity to consume
•
•
•
•
•
•
Industrialized economy
Surplus capacity in consumer goods industries
Availability of other resources of production
No change in the distribution of income
No change in prices
Acceleration effect ignored
Leakages of Multiplier
• Increase in Income due to increase in initial
investment, does not go on endlessly.
• The process of income propagation slows down
and ultimately comes to halt. Causes responsible
for the decline in income are called leakages .
• In words of Peterson ,” income that is not spent
on currently produced consumption goods and
services may be regarded as having leaked out of
income steam .”
• The more powerful these leakages are ,the
smaller will be the value of multiplier.
Some important leakages
•
•
Idle saving :idle saving leads to equivalent fall in
marginal propensity to consume .it results into
fall in the value of multiplier. As a matter of fact
,higher the MPS greater is the leakage from
income propagation and smaller is the value of
multiplier.
Purchase of govt.: securities and shares : when
some part of increased income is used to
purchase old shares and govt. securities means
this part of income is not spent on consumer
goods . Consequently , the flow of income
stream falls.
• Paying of old debts :That part of increased
income which is utilised in paying of old debts is
obviously not spent on cosumption .This leakage
also constricts the process of income generation .
• Import: liquidity drains out of the system
equivalent to the value of imports through which
propensity to consume falls limiting the multiplier
effect of increased investment .
• Excess stock of consumption goods: increase in
income leads to increase in consumption .if the
increased demand for consumer goods is met out
of the existing stocks ,means new consumer
goods are not produced that results into
hampering the growth of multiplier.
• High liquidity Preference: it means if people want to
hold more money in cash for transaction,
precautionary and speculative motives, it would
imply less expenditure also serves as a leakage of
multiplier.
• Price Inflation: under inflationary situation people
have to spend more money to buy same amount of
goods and services as before. The effect is that there
will be not much increase in level of consumption and
ultimately multiplier effect will remain limited.
• Taxation system : if taxes on goods and progressive
taxes on income are increased ,there will be no
appreciable increase in consumption despite increase
in income . As a result process of income propagation
slows down .
• Undistributed profits of companies : Many
companies do not distribute all the profits among
the shareholders; as they keep a part of it as a
reserve fund. The undistributed profits also
serves as a leakage of the multiplier because this
amount is not made available to the shareholders
who could use it as a consumption expenditure.
Importance of Multiplier
• Income Propagation: concept of multiplier tells
us that income propagation is a natural process.
It tells that increase in employment, income and
output is due to increase in investment .
*Income is generated in an economy in much the
same way as a stone thrown in a lake causes
ripples .*
• Importance of Investment: it is the initial
increase in the investment that results in
multiple increase in income . As a matter of fact,
investment is that dynamic element on which
changes in employment depend.
• Trade Cycles: trade cycles are those cycles which tell
business fluctuations take place over a period of long
run. Sometimes there is a boom and at another time
there is depression in business. So multiplier helps in
understanding trade cycles .
• Full Employment: Multiplier’s concept is of great
importance while formulating policy regarding full
employment. it shows that to attain full
employment situation a thrust of net investment
should be made in the economy .
• Deficit Financing: deficit financing helps in removing
bad effects of depression. it is so because as a result
of deficit financing investment increases and
increase in investment causes multiple increase in
income in terms of multiplier effect.
• Equilibrium between Saving and Investment: According
to keynes theory of Employment , Equilibrium is
established when Saving and Investment are equal.
Equilibrium between Saving and Investment can be
achieved through change in the level of income. If
saving is low in an economy, it can be known from the
concept of marginal propensity to save how much
increase in income is needed to get the required
increase in saving. And to increase the level of income
how much investment is needed, can be determined
from the co-efficient of multiplier.
• Public Investment: concept of multiplier testifies that if
during depression, a little increase in public investment
is made, it will lead to multiple increase in income such
an increase in income will help in controlling
depression and unemployment.
Multiplier and Public Investment
• Concept of multiplier propounded by John
Meynard Keynes lays emphasis on the significance
and utility of public investment .
• Public investment refers to govt. expenditure on
public works and public welfare activities.
Purpose of this investment is not to earn profit ,
as is the case with private investment. It is called
autonomous investment, because it is
independent of profit motive .
• Its objective is to increase employment and
stimulate business during a cute depression
Relationship between Multiplier and
Public investment
• There is a close relationship between multiplier
and public investment . Concept of multiplier
proves that if during depression public investment
is increased a little, it will lead to multiple
increase in income .
• With a view to realizing full-multiplier effect of
investment , the govt. should take care of the
following factors :
• Public investment should be made in those areas
where MPC i.e (marginal propensity to consume) is
maximum. MPC is more in underdeveloped and
backward regions.
• Public investment should be undertaken at a time
when multiplier effect is maximum. It is maximum
during boom and depression periods .
• It is essential for the working of multiplier that on
account of increase in Public investment, there
should be increase in the total investment in
country .
• Income that increases on account of Public
investment should not be concentrated in hands of
the rich class as its marginal propensity to consume
is low .
• As soon as economy attains full employment
situation, the public investment should be
slashed considerably. If it is not done, the
multiplier effect of public investment may give
rise to inflation in the economy.
• public investment should be so coordinated as to
get maximum multiplier effect. At the same time,
care should be taken to ensure that as soon as
signs of boom situation appear, the govt. should
slow down public investment or vice –versa .
• Tautological : it is a Tautological concept wherein the
same thing has been said repeatedly in different
words .it does not express anything new.
• Relation between Income and Consumption: the
assumption of multiplier that MPC is less than unity
and remains constant is wrong ; because, in fact,
Relationship between income and consumption is not
so simple as is assumed by keynes.
• Effect of Acceleration is Ignored: it does not take into
consideration, change in investment as a result of
change in consumption. In fact, multiplier is
influenced not only by investment but also by
consumption expenditure. if consumption
expenditure is increased, the multiplier will continue
to work, although no investment is undertaken.
• Unnecessary importance to Deficit Financing :
concept of multiplier has given Unnecessary
importance to Deficit Financing in preference to
many important and appropriate methods of
monetary policy.
• Practical Defects : the Practical defects of concept
of multiplier lies in the fact that it has made
investment a casual factor whereas, in reality,
investment is the effect of saving to a large extent.
• Complete Elasticity in the Supply of Funds and
Supply of Consumer’s Goods.
Types of Multiplier
Employment Multiplier
• The employment multiplier is the ratio of
increase in total employment to the increase in
primary or original employment .
Foreign Trade Multiplier
• The ratio of change in total income to change in
export income is called foreign trade multiplier.
Employment Multiplier
• This concept is related to increase in employment.
According t∆o R.F khan increase in investment will cause in
increase in employment not only in those very industries
where in such investment has been made but in other
industries also.
• Employment increases in two ways.
1) Primary Employment
2) Secondary Employment
• Employment Multiplier can be expressed by an equation as
follows.
K1=N2/N1
(Here k1=employment multiplier; N2= Total employment;
N1= Primary employment.)
Foreign Trade Multiplier
• When foreigners import goods from our country ,
domestic export industries earn revenue. Income of
those people who work in export industries will
increase. They will increase their consumption
expenditure.
• The effect of it will be that, income of those who
produce consumer goods will rise.
• In this way increase in export income, aggregate
income increases many times more.
• It can be expressed by an equation as follows.
Kf= ∆Y/ ∆E .
Working Of Multiplier in under
developed countries
Multiplier does not work in the same manner in
under developed countries as in developed
countries . According to keynes, in developed
economy an increase investment leads to
multiple increase in income because of the
multiplier effect. The increase in income depends
on MPC.
• No doubt, MPC is high in under developed
countries, the value of multiplier is low.
Reason for why
the value of
multiplier is low,
despite of high
degree of MPC
• Working of multiplier holds good when a part of an
increased income, as a result of increase in
investment, is spent in the second round. On account
of this expenditure in the second round there will be
a corresponding increase in income . In this way
income will go on rising. But ,
1. In underdeveloped countries ,when income
increases initially as a result of increase in
investment then this increased income when spent
in the market is not matched by the corresponding
flow of goods and services .
2. That is, in these economies increase in consumption
expenditure is not accompanied with increase in
production. Ultimately increase in consumption
expenditure is followed by rise in prices
1. Firstly, they will make more use of their
produce for self consumption it will cause
corresponding fall in the marketable surplus.
2. Secondly, they will increase their demand for
industrial goods, but the production capacity
of the firms producing industrial goods is also
limited . Hence despite increase in demand
for industrial goods their real output does
not increase ; rather prices begin to rise.
• Another reason being that: when income of the
people , in these economies increases it pushes
up the demand for food because of extreme
poverty.
• Increased demand for food and other agricultural
products leads to increase in the income if the
farmers. The increased income the farmers will
not cause any increase in investment because;
1. Supply of agricultural products is inelastic , and
2. In under developed countries there is a shortage
of resources for the development of agriculture .
• So, farmers will use their increased income in
two ways :
• According to Dr Rao, keynes concept of multiplier is based
on certain assumptions, such as :
1. Open employment
2. Industrialized economy
3. Excess capacity in consumption goods industries
4. Comparatively elastic supply of raw material and working
capital .
• All these assumptions are lacking in under developed
countries. In these countries there is disguised
unemployment instead of involuntary unemployment .
• Hence for want of assumptions of multiplier in under
developed countries this concept is not fully applicable to
them. In these countries since supply does not increase
immediately in response to increase in investment, prices
and not real income begin to rise.