- 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 [2]
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
Key Points
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 = ∞.
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: Leakages of Multiplier
- Savings: Higher saving (high MPS) reduces consumption and limits the multiplier effect.
- Imports: Spending on imports leaks income out of the domestic economy.
- Inflation: Rising prices absorb increased income without raising real output.
- Taxes & undistributed profits: Reduce disposable income and consumption.
- Hoarding & high liquidity preference: Money held idle reduces spending.
- Debt repayment & purchase of old securities: Do not create new income or employment.
- Excess stocks: Demand met from existing stocks stops further income generation.
- Public investment crowding out: May raise costs or interest rates, discouraging private investment.
Key Points: Importance of Multiplier
- Explains income, output, and employment generation through increased investment.
- Helps achieve full employment by showing the cumulative effect of investment.
- Useful in controlling trade cycles—increase investment during depression, reduce it during boom.
- Guides government policy, especially public investment and deficit financing, to manage inflation and deflation.
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.
