- Works only at less than full employment; at full employment it causes inflation, not real output.
- Requires excess capacity in consumer goods industries; otherwise the effect is limited.
- Needs continuous investment and constant MPC, which is unrealistic.
- Assumes a closed economy; imports act as leakages and reduce multiplier effect.
- Ignores the accelerator effect and works better in industrialised economies than agricultural ones.
Definitions [3]
Define multiplier.
- The multiplier is defined as the ratio of the change in national income to the change in investment.
- If AI stands for increase in investment and AY stands for resultant increase in income, the multiplier K = `"AY"/"AI"`.
- Since AY results from AI, the multiplier is called investment multiplier.
According to Keynes, “Investment multiplier tells us that when there is an increment in aggregate investment, income will increase by an amount that is K times the increment of investment.”
According to Prof. Dillard, “Investment multiplier is the ratio of increase in income to a given increase in investment.”
Definitions: Multiplier
- “Investment multiplier is the ratio of increase in income to given increase in investment.” —Prof. Dillard
- “The multiplier is the number by which the investment can be multiplied in order to get resulting change in income.” —Samuelson
- “Investment multiplier is the coefficient relating to an increment of investment to an increment of income.” —Hansen
- “Investment multiplier tells us that where there is an increment of aggregate investment, income will increase by an amount which is K times the increment of investment.” —Keynes
Definition: Leakages of Multiplier
According to Prof. Peterson, ‘Leakage refers to that income which is not spent for currently produced consumption goods and services may be regarded as having leaked out of income stream.’
Formulae [3]
Formula: Employment Multiplier
If:
- N2 = primary employment
- N = total employment
- K′ = employment multiplier
Then:
\[N=K^{\prime}N_2\quad\Rightarrow\quad K^{\prime}=\frac{N}{N_2}\]
Formula: Foreign Trade Multiplier
\[K=\frac{1}{I\times S}\]
Where:
- K = foreign trade multiplier
- I = marginal propensity to import
- S = marginal propensity to save
Formula: Price Multiplier
\[K_p=\frac{PL}{P}\]
Where:
- Kp = price multiplier
- PL = ultimate change in general price level
- P = change in the price of the basic commodity
Theorems and Laws [1]
The Balanced Budget Theorem
The balanced budget multiplier is always equal to one.
This means: if the government raises both its spending and taxes by the same amount, national income rises by exactly that amount — no more, no less.
Key Points
Key Points: Multiplier
- Kahn → Employment Multiplier (employment to employment ratio)
- Keynes → Investment Multiplier / Income Multiplier (investment to income ratio)
- The multiplier shows a direct, positive relationship between investment and income.
- The multiplier is always expressed as a ratio: \[\frac{\Delta Y}{\Delta I}\].
- The concept highlights that the final effect on income is always a multiple of the original investment.
- The multiplier process works because one person's expenditure becomes another person's income, which is then partly spent again — creating successive rounds of income generation.
Key Points: Size of Investment Multiplier
- The multiplier (K) depends on MPC and MPS.
- K = 1 / (1 − MPC) or K = 1 / MPS.
- Higher MPC → higher multiplier; higher MPS → lower multiplier.
- If MPC = 0, K = 1; if MPC = 1, K = ∞.
Assumptions with Real Life Examples
| Assumption (short) | Simple example/analogy | |
|---|---|---|
| 1 | Only autonomous investment changes (no induced investment) | The government announces a one-time ₹500 crore dam project. This decision is taken independently, not because people’s incomes have already started rising. The dam project is the “first stone” thrown into the pond. |
| 2 | MPC is constant | A worker always spends 80 paise from every extra ₹1 earned, whether the bonus is ₹1,000 or ₹10,000. The spending rule “spend 80%, save 20%” never changes from round to round. |
| 3 | Consumption depends only on current income | A teacher gets a ₹5,000 salary hike this month and immediately raises monthly spending by ₹4,000, just based on the new salary. She does not wait for next year’s promotion or think about past savings. |
| 4 | No time lags in the process | Construction workers are paid today, they go to the market the same day, shopkeepers instantly restock and pay their suppliers, and suppliers pay their workers immediately. There is no gap between earning and spending in any round. |
| 5 | A new level of investment is maintained | The government fully funds a 3‑year highway project without stopping or cutting the budget midway. Every month, the same amount of construction spending continues until the road is completed. |
| 6 | There is a net increase in investment | A new hospital is being built in a city that previously had only one. This is an additional hospital, not just repairing or replacing the old one. Total health infrastructure in the city actually increases. |
| 7 | Consumer goods are available | When workers earn more, shops have enough rice, clothes, mobiles, etc., in stock. If 1,000 workers walk into markets to spend their extra income, they all find the goods they want without stock‑outs. |
| 8 | Other production resources are easily available | A biscuit factory that wants to increase output can easily hire more workers, buy more flour, sugar and oil, and rent extra machinery. None of these inputs is in serious shortage. |
| 9 | Surplus capacity in consumer goods industries | A biscuit factory currently operates only one shift (8 hours). When demand rises, it simply adds a second shift using existing machines and idle workers, so output can increase quickly. |
| 10 | The economy is industrialised | In an industrial economy, a garment factory can double shirt production within weeks by running more shifts. In a mostly agricultural economy, increasing wheat production may take a whole cropping season, so the response is slow. |
| 11 | Prices remain constant | A loaf of bread costs ₹40 before and after the multiplier process. When income rises, people buy more loaves, but the price per loaf does not rise, so all extra money translates into more quantity, not higher prices. |
| 12 | Closed economy (no foreign trade) | A self‑sufficient island where every rupee earned and spent stays within the island. When people buy clothes or phones, they are always made locally; no money leaves the island to pay foreign producers. |
| 13 | Less than full employment (idle resources exist) | Many construction workers are unemployed in a city. A new metro project hires them. These workers were sitting idle earlier; now they produce extra output and earn income, so total real output in the economy rises. |
| 14 | Accelerator effect ignored (no extra induced investment from higher consumption) | A shop’s sales increase because people have higher income, but in the simple model we pretend the shop owner does not respond by opening a new branch or expanding the shop. Only the original investment (e.g., road project) is considered. |
Key Points: Assumptions of Multiplier
- Only autonomous investment changes; induced investment is absent.
- MPC is constant and consumption depends on current income.
- No time lag in the multiplier process; investment remains constant.
- Economy is closed, industrialised, and operates at less than full employment.
- Prices remain constant and resources, consumer goods, and surplus capacity are available.
Key Points: Static Multiplier
- In a static multiplier, there is no time lag; increase in investment raises income in the same period.
- All variables (income, consumption, investment) belong to the same time period.
- Multiplier works in two directions:
Forward: Increase in investment → multiple increase in income.
Reverse: Decrease in investment → multiple fall in income. - Size of income change depends on MPC and saving–investment equality.
Key Points: Dynamic Concept of Multiplier
- The dynamic multiplier considers the time lag between changes in investment and changes in income.
- Income adjustment takes place over successive periods, not instantly as in the static multiplier.
- Consumption depends on past income, and investment in one period affects income in the next period.
- Since MPC changes over time, the multiplier process becomes dynamic and more realistic.
Key Points: Explanation of Dynamic Multiplier
- Dynamic multiplier shows how income increases over time with time lags, not instantly.
- Income rises in successive periods as consumption depends on past income.
- With a single investment, income expansion stops unless MPC = 1.
- With repeated investment, income rises gradually and finally stabilises (or becomes infinite if MPC = 1).
Key Points: Limitations of Multiplier
Key Points: Types of Multiplier
- Employment Multiplier: Shows how much total employment increases due to an initial increase in investment.
- Foreign Trade Multiplier: Explains how exports raise national income through repeated spending.
- Price Multiplier: A rise in price of one good leads to a multiple rise in overall price level.
- Consumption Multiplier: Increase in consumption goods supply leads to multiple rise in investment, mainly relevant for underdeveloped economies.
Key Points: Balanced-Budget Multiplier
- When government expenditure (ΔG) and taxes (ΔT) increase by the same amount, the budget is balanced.
- The Balanced Budget Multiplier (BBM) is always equal to 1.
- This means national income increases by exactly the same amount as ΔG.
- So, ΔY = ΔG, even when taxes rise along with government spending.
