Multiplier

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 Multiplier
Keynes’s multiplier is known as
Investment or Income multiplier. The
essence of multiplier is that total increase
in income, output or employment is
manifold the original increase in
investment.

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 Explanation
The multiplier is the ratio of increment in
income to the increment in investment. If
ΔI stands for increment in investment and
ΔY stands for the resultant increase in
income, then multiplier is equal to the ratio
of increment in income (ΔY) to the
increment in investment (ΔI). Therefore,
k = ΔY/ΔI
where k stands for multiplier.
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 Example
• Suppose Government undertakes investment expenditure
equal to Rs.100 crores on some public works, say the
construction of rural roads.

• For this Government will pay wages to the laborers engaged,

prices for the materials to the suppliers and remunerations to
other factors that make contribution to the work of road-
construction. The total cost will amount to Rs.100 crores.
 
• This will increase incomes of people equal to Rs.100 crores.
But this is not all. The people who receive Rs.100 crores will
spend a good part of them on consumer goods.

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 Example (Continued)
• Suppose Marginal Propensity to Consume (MPC) of the people
is 4/5 or 80%, then out of these 100 crores they will spend
Rs.80 crores.

• But those who receive these Rs.80 crores will also in turn spend
these incomes, depending upon their MPC. If their MPC is also
4/5, then they will spend Rs. 64 crores on consumer goods.

• This will further increase incomes of some other people equal

to Rs.64 crores. In this way, the chain of consumption
expenditure would continue and the income of the people will
go on increasing.

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 Example (Continued)
• But every additional increase in income will be progressively
less since the part of the income received will be saved.

• We can now see that due to increase in investment by Rs.100

crore, income will increase by many times more.

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Derivation of Investment Multiplier (1 of 4)

Increase in Income

ΔY = 100 + [100 (4/5)] + [100 (4/5) 2] + [100 (4/5) 3] + [100

(4/5) 4]…

ΔY = 100 [1 + (4/5) + (4/5) 2 + (4/5) 3 + (4/5) 4 … ]

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Derivation of Investment Multiplier (2 of 4)

Since the above series is one of geometric progression.

Therefore, increase in income:

………(i)

ΔY = 100 x 5

ΔY = 500

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Derivation of Investment Multiplier (3 of 4)

Since we know that MPC is 4/5, the investment of Rs.100 crores

leads to the increase of national income by Rs.500 crores.
Multiplier, here, is equal to 5. We can express this in a general
formula. If ΔY stands for increase in income, ΔI stands for
increase in investment and MPC for marginal propensity to
consume, we can write equation (i) above as follows:

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Derivation of Investment Multiplier (4 of 4)

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 Algebraic Derivation (1 of 3)

Writing the equation for the equilibrium level of income, we have

Y = C + I ………. (1)

As in multiplier analysis we are concerned with changes in income

induced by changes in investment. Rewriting the equation (1) in terms
of changes in the variables we have

ΔY = ΔC + ΔI ……….(2)

In the simple Keynesian model of income determination, change in

investment is considered to be autonomous or independent of changes
in income while changes in consumption are function of changes in
income.
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 Algebraic Derivation (2 of 3)

In the consumption function,

C = a + bY

Where ‘a’ is a constant term, ‘b’ is marginal propensity to

consume which is also assumed to remain constant. Therefore,
change in consumption can occur only if there is change in
income. Thus

ΔC = b ΔY ……….(3)

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 Algebraic Derivation (3 of 3)

Substituting (3) into (2) we have

ΔY = b ΔY + ΔI
ΔY – b ΔY = ΔI
ΔY (1 – b ) = ΔI

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Keynes Income Multiplier

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Multiplier (Savings & Investment)

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 Assumptions of Multiplier Theory
• Marginal propensity to consume remains constant as
the income increases.
• No indirect effects of investment.
• No time lag between investment and the resultant
increment in income.
• Excess capacity exists in the consumer goods
industries.
• No leakages from imports due to closed economy.
• Constant prices.

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 Business Cycles
Business Cycles (Definition by Burns and Mitchel)
Business cycles are a type of fluctuation found in the
aggregate economic activity of nations that organize their
work mainly in business enterprises. A cycle consists of
expansions occurring at about the same time in many
economic activities, followed by similarly general
recessions, contractions, and revivals which merge into
the expansion phase of the next cycle; this sequence of
changes is recurrent but not periodic; in duration
business cycles vary from more than one year to ten or
twelve years.

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 Important aspects of Business Cycle
Definition
Aggregate Economic Activity
Business cycles are defined broadly as fluctuations of
“aggregate economic activity” rather than as
fluctuations in a single specific economic variable such
as real GDP. Although real GDP may be the single
variable that most closely measures aggregate
economic activity.

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 Important aspects of Business Cycle
Definition
Expansions and Contractions
The period of time during which economic activity is
falling is a contraction or recession. If the recession is
particularly severe it becomes a depression. The
period of time during which aggregate economic
activity grows is an expansion or a boom. After
reaching the high point of expansion, the peak,
aggregate economic activity begins to decline again.
The entire sequence of decline followed by recovery,
measured from peak to peak or trough to trough, is a
business cycle.

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 Important aspects of Business Cycle
Definition
Comovement
Business cycles do not occur in just a few sectors or in
just a few economic variables. Instead, expansions or
contractions “occur about the same time in many
economic activities.” The tendency of many economic
variables to move together in a predictable way over
the business cycle is called comovement.

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 Important aspects of Business Cycle
Definition
Recurrent but not periodic
The business cycle isn’t periodic, in that it does not
occur at regular, predictable intervals and doesn’t
last for a fixed or predetermined length of time.
Although business cycle isn’t periodic, it is
recurrent; that is, the standard pattern of
contraction-trough-expansion-peak occurs again
and again in industrial economies.

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 Important aspects of Business Cycle
Definition
Persistence
The tendency for declines in economic activity to be
followed by further declines, and for growth in
economic activity to be followed by more growth, is
called persistence. Because movements in economic
activity have some persistence, economic forecasters
are always on the lookout for turning points, which
are likely to indicate a change in the direction of
economic activity.

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Business Cycles

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