The concept of the multiplier process became important in the 1930s when John Maynard Keynes suggested it as a tool to help governments to achieve full employment. This macroeconomic “demand-management approach”, designed to help overcome a shortage of business capital investment, measured the amount of government spending needed to reach a level of national income that would prevent unemployment.
The theory of multiplier occupies an important place in the modern theory of employment. The concept of multiplier was first developed by F.A. Kahn and was then refined by Keynes in 1930s. Keynes multiplier is also known as the “Investment or income multiplier” as he refers to the concept with increase in investment and income. The essence of multiplier is that total increase in income; output and employment manifold the original increase in the investment.
Let us consider that the government undertakes investment expenditure on some public works, say the construction of rural roads. For this the government remunerate to all who are contributing to the work of the road building. Since the income of the road building contributors has increased they will be spending this income on their consumptions and savings. When they purchase their consumer goods, the income of the people who sell these goods increases, who will further be spending the income on their consumptions and savings. This will further increase incomes of some other people and the chain of consumption expenditure would continue and the income of the people will go on increasing. But every additional increase in income will be progressively less since a part of the income received will be saved. Thus we see that the income will not increase by only the initial investment but by many times more.
The higher is the propensity to consume domestically produced goods and services, the greater is the multiplier effect. The government can influence the size of the multiplier through changes in direct taxes. For example, a cut in the basic rate of income tax will increase the amount of extra income that can be spent on further goods and services.
Another factor affecting the size of the multiplier effect is the propensity to purchase imports. If, out of extra income, people spend money on imports, this demand is not passed on in the form of extra spending on domestically produced output. It leaks away from the circular flow of income and spending.
We can arrive to same conclusion with the help of an algebraic expression and obtain a numeric value of the multiplier as follows:
Let k=multiplier Y= income C=consumption I= Investment
If ∆I stands for change in investment and ∆Y stands for resultant change in income
Then k = ∆Y / ∆I
The equation for equilibrium level of income is
Y= C + I …………. (1)
As in the multiplier analysis we will consider the change in income ∆Y which will lead to change in consumption ∆C and change in investment ∆I
Rewriting equation (1) we get
∆Y= ∆C + ∆I …………. (2)
Dividing both sides of equation (2) by …….. ∆Y
∆Y / ∆Y = ∆C / ∆Y + ∆I / ∆Y
1 = ∆C / ∆Y + ∆I / ∆Y
∆I / ∆Y = 1 - ∆C / ∆Y
∆Y / ∆I = 1 / (1-∆C / ∆Y)
k = 1 / (1-∆C / ∆Y)
But ∆C / ∆Y means change in consumption out of change in income which nothing but the Marginal Propensity to Consume (MPC).
k = 1 / (1-MPC)
Now if we also know that Marginal Propensity to Save (MPS) is nothing but “1-MPC” ……………Therefore
k = 1 / MPS
In other words we can say that
The value of the multiplier will be high if the value of the Marginal Propensity to Consume is high. Or
The value of the multiplier will be high if the value of the Marginal Propensity to Save is low.
The multiplier effect of local re-spending can be easily represented as:
A spending that started with $1 is re-spent number of times and the value it...