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### Multiplier theory

The multiplier is an important concept used in macroeconomics. This concept was developed, by R.F. Khan in 1931 in his article, Relation of home investment to unemployment, the concept of multiplier developed by Khan is known as employment multiplier. Keynesian multiplier concept is based on marginal propensity to consume (MPC).

The multiplier theory explains the effect of changes in the investment upon the consumption expenditure and the resulting generation of income. The theory of multiplier is an integral part of the General theory of employment since it establishes a precise relationship between aggregate employment and income and the rate of investment, given the marginal propensity to consume According to the multiplier theory, when there is an increment of aggregate investment, income will increase by an amount, which is K times the increase of investment. It explains the cumulative effects of changes in investment on income through their effects on consumption expenditures. It helps us to understand the dynamic process of income generation.

According to Keynes, multiplier is the ratio of final change in income to the initial change in investment, the concept of multiplier is explained in the following formula,

According to Samuelson, multiplier means “the number by which the change in investment must be multiplied in order to present us with the resulting change in income.

The multiplier is determined by the propensity to consume, the relationship between the MPC and the investment multiplier is shown by the following arithmetic formula,

For example, if MPC is 3/4 the multiplier will be

#### Assumptions of Multiplier

The Keynesian Concept of investment multiplier is based on the following assumptions:-

1) The MPC is constant.

2) The concept of multiplier is applicable to the economy based on industry.

3) Closed economy is another assumption.

4) There should be net increase in investment,

5) There is unemployment in a economy.

6) Monetary and fiscal policies remain stable so that they do not affect the propensity to consume.

7) Induced investment is made in an economy.

8) Excess capacity exists in the economic system. The assumption is that the economy operates at less than full employment.

9) No time lags between successive expenditure on consumption in the process of multiplier. 10)Resources required for the production process are available in a economy.

#### Working of Multiplier

Explains the cumulative effect of a change in investment on income via consumption expenditure, It is the mechanism through income and investment expansion. Now we will see the functioning of multiplier with the help of following assumed example.

.70

Let us suppose that MEC is 4/5 i.e. 75% The initial investment is Rs 1000 crores, The process of income generation from the original (initial) investment is shown in the Table No 4,2.

Table No 5.2

Working of Multiplier

MPC= 4/5

Table No 5,2 shows us the process of working of multiplier in a economy, in the various stages. The initial (originally) investment is assumed of Rs. 1000/- The MPC is 4/5 so that in the phase or stage, increase in consumption expenditure and induced income is of Rs. 800/-

The second stage, we observe that induced come in and consumption expenditure becomes Rs 640/- and Rs 512 /- respectively. In this way the working of multiplier process is going on up to the level induced income and expenditure on consumption

becomes O, Thus. With the help of original investment of Rs.1000/- the economy can grow induced income and consumption of Rs 5000/- and Rs. 4000/- respectively, It denotes that multiplier

becomes 5, the process of multiplier is the cyclical effect of induced income and consumption. The concept of investment Multiplier is shown with the help of following figure No. 5.3

OX axis shows the change in income and OY axis consumption and investment is shown. Above figure shows us the working of multiplier in a 4/5 MPC ratio. Zero saving condition shown on line ON. E, E1 and E3 are the three equilibrium points which shows us the changes in income and investment level of an economy. The equilibrium point E2 denotes the zero savings situation. Thus, the process of working of multiplier depends on MPC.

#### LEAKAGES OF THE MULTIPLIER

The concept of multiplier seems to be very attractive theoretically, but in practice, the functioning of multiplier arises some limitations or leakages. These limitations of multiplier are as follows. They are-

#### 1. Increase in the MPS

The higher the marginal propensity to save, the greater the leakages of additional income out of the income. In a dynamic economy, the MPC or MPS is not constant. With increases in income MPS rises. As a result, the multiplier value may fall.

#### 2. Debt Cancellation

Paying back of debts taken by people reduces the value of the multiplier since consumption is reduced.

#### 3. Hoarding Idle Cash Balances

If people prefer to hold liquid cash than spend it on consumption goods, it will lead to a leakage from the income stream and reduce the value of the multiplier.

#### 4. Imports

The income spent on imports will not lead to income generation within the domestic country, and hence leads to a restriction of the value of the multiplier.

#### 5. Purchase of Old Shares and Securities

If the newly generated income is used to buy old stocks, shares and securities, consumption will be less and as a result, the value of the multipliers will be low.

#### 6. Inflation

Rise in the prices adversely affects the real consumption of people. Hence consumption will not increase during inflation. This also affects the value of the multiplier.

#### 1. It is a static phenomenon

It does not explain the dynamic change. It explains the process of income propagation from one point of equilibrium to another under static assumptions. The actual sequence of events is not explained.

#### 2. It is a timeless phenomenon

Keynes assumed an instantaneous relationship between income, consumption, and investment. However, there are time lags between consumption and income. Hence according to modern economists, multiplier effect takes time to make an impact.

#### 3. No Empirical Evidence

There is no empirical evidence to prove the operation of multiplier effect. It does not tell us anything about the real world.

#### 4. It gives too much importance to Consumption

According to Gordon the emphasis is exclusively on consumption only.

#### 5. Neglected the Derived Demand Phenomenon of Investment in Capital Goods Sectors

The theory has neglected the derived demand phenomenon of investment in capital goods sectors. It fails to establish a relationship between the demand for capital goods and consumption goods.

#### 6. It is a Myth

Some economists like Prof. Hazlitt hold that the multiplier concept is only a myth there cannot be a precise mechanical relationship between investment and income.

#### STATIC & DYNAMIC MULTIPLIER

Depending on the purpose of analysis sometimes a distinction is made between the static multiplier and the dynamic multiplier. The static multiplier is also called comparative static multiple simultaneous multiplier, logical multiplier, timeless multiplier, legless multiplier and instant multiplier.

The concept of static multiplier implies that changes in investment causes change in income instantaneously. It means that there is no time lag between the change in investment and the change in income. It implies that the moment a rupee is spent on investment project, society’s income increases by a multiple. Let us explain the concept of the dynamic multiplier also known as period and sequence multiplier.

The concept of dynamic multiplier recognizes the fact that the overall change in income as a result of the change in investment is not instantaneous. There is a gradual process by which income change as a result of change in investment or other determinants of income. The process of change in income involves a time lag. The multiplier process works through the process of income generation and consumption expenditure. The dynamic multiplier takes into account the dynamic process of the change in income and the change in consumption at different stages due to change in investment. The dynamic multiplier is essentially a stage-by stage computation of the change in income resulting from the change in investment till the full effect of the multiplier is realized.