Paper 8B

Intermediate

UNIT II Multiplier

Dr. Neelam Tandon

Spending determines income, but income also determines spending.

Equilibrium is reached when actual income equals intended

spending,

Y = C + I + G + (X-M)

This equilibrium condition can also be expressed in another way,

namely,

S + T + M = I + G + X

Intended withdrawals/leakages = Intended injections

In the Keynesian model of income determination discussed in this

chapter, the adjustment process from one equilibrium output level

to another is based on unintended inventory changes. These are

defined as the difference between actual output and aggregate

demand

Firms try to maintain an optimal inventory stock;

1. If Effective AD > AS (Planned Output)

2. Unplanned Inventory

3. Actual Production /Output

4. Employment

4. Total production = aggregate demand

# The largest part of aggregate demand comes from consumption

spending

C = a + bYD with 0 < b < 1

YD = Y - TA + TR

If we assume for simplicity that TA = TR = 0, it follows that YD =

Y, and thus the savings function can be derived from YD = C + S,

that is,

C= a +by

Or

S = - a + (1 - b) Y

(1 – b) is the marginal propensity to save.

Aggregate Output

/Income

Aggregate Demand =C+I

Aggregate Supply

Panel A Equilibrium AD= AS or C+I =C+S

Panel B Equilibrium Savings (leakages) =

Investment(injection)

Change in Autonomus Investment : Multiplier and National

Income

Increase in Autonomous investment increases consumption

demand and income in the economy

In underdeveloped countries Multiplier Impact is high but value

is low due to lack of productivity efficiency of labour and capital

In other words, any increase in autonomous Investment spending by

I will increase national income by Y = [1/(1 - c)](I) =k

K = Y/I = 1/(1-MPC) = 1/(MPS) Multiplier

The output in the economy is a multiple of the increase or decrease

in investment spending.

The Maximum value of multiplier is infinity; if MPC=1

For example, a Rupees 1 million increase in the total amount of

investment in an economy will set off a chain reaction of increases in

expenditures.

Those who produce the goods and services that are ultimately

purchased as a result of the Rupees 100 million investment will

realize the Rupees100 million as increases in their incomes.

If they, in turn, collectively spend about 0.5 of that additional

income, then a total of Rupees 50 million further 25 million

followed by 12.5 million and so on .

K = Y/I = 1/(1-MPC) = 1/(MPS)

K=1/1-0.5 = k= 1/0.5 = 2

Income will increase from 100ˣ 2= Rupees 200 million

Increase in National Income will be Rupees 200 million with 100

million investments

Note:

Increase in income due to increase in initial investment, does not go

on endlessly. The process of income propagation slows down and

ultimately comes to halt. The decline in income is due to leakages.

Due to leakages

If MPS is higher multiplier impact will be less. Similarly there are

other leakages that results in lowering down the consumption

expenditure for example:

1. Progressive taxes results in reducing the impact of increase in

income

2. High Liquidity Preference and low MPC

3. Excess of Inventory investment and high reliance on Imports

4. Investment in existing financial products, shares, bonds,

Government securities

5. High debt obligations

6. High Retained earnings of Corporate

7. Scarcity of Supply despite high consumption demand

8. Economy is at full employment hence increase in demand would

lead to inflation in the economy

# Illustration 1

In an economy, every time income rises, 75 percent of rise in income

is spent on consumption. If the investment in the economy increases

by Rs 750 million

a. Find change in Income

b. Change in saving

2. National Income =2500 , Autonomous consumption =300,

Investment expenditure =100 (all figures in Rupees crores)

Find MPC and MPS

3. If savings function= -10 +0.2Y , I= 50 crore

Find Equilibrium level of Income, consumption and if investment

increases by INR 5 crore. Find new level of income and consumption

-10 +0.2Y =50

0.2Y=60

Y = 60/0.2

Y= 300 crore

Y= C+S

300= C+50

C=250

Given ∆I= 5 crore

MPS = 0.2

MPC = 1- MPS

MPC= 0.8

K= 1/ (1-MPC) = ∆Y/ ∆I

K= 5 = ∆Y/ 5

25 crore = ∆Y

New Income = 300+ 25 = 325 Crore

Increase in consumption = ∆Y ×MPC

= 25 × 0.8

=20.0 crore

At Equilibrium Y= C+I+G

Government Transfer Payments and its impact on Income

The formula and size of the expenditure multiplier is always

determined by the particular model of the expenditure sector that is

being used.

If Government expenditure increases by 5 percent

Tax rate increases by 5 percent

Disposable income will remain unchanged.

There is no induced increase in consumption, as the effect of higher

taxes exactly offsets the effect of the income expansion, leaving

disposable income unchanged.

Foreign Trade Multplier

Higher the value of ‘m’ (propensity to import) lower will be the

impact of Investment and government expenditure on the

national income of the country. Direct effect on Income and

induced effect on consumption of domestic goods results in lower

domestic production. Increase in imports per unit of the income

leads to leakages in the economy.

Question:

Due to recession in an economy, government expenditure increases

by INR 6 billion, if MPC =0.8 compute the increase in GDP (2

Marks)

Government Expenditure Multiplier = ∆Y/∆G = 1/ (1-MPC)

Question : If Consumption = 200+ 0.60 Yd

Government Spending = 150 crore

# Explain in words the effect of an increase in the marginal

propensity to save on the size of the expenditure multiplier and

the level of equilibrium income.

# Comment on the following statement:

“When aggregate demand falls below the current output level, an

unintended inventory accumulation occurs and the economy is no

longer in equilibrium.”