Theory gives great importance to increase in public investment and government
spending for raising the level of income and employment.
Both consumption and investment create employment.
But both have complementary relationship with one another.
When investment increases, consumption increases too and helps in
creating employment. It is only
when the level of full employment has been reached that investment and
consumption become competitive instead of being complementary; then increase in
one will reduce the other, one will be at the expense of the other.
is known as Employment Multiplier, and Keynes’ Multiplier is known as
Investment Multiplier. According to
Kahn’s Employment Multiplier, when government undertakes public works like
roads, railways, irrigation works then people get employment.
This is initial or primary employment.
These people then spend their income on consumption goods. As a result, demand for consumption goods increases, which
leads to increase in the output of concerned industries which provides further
employment to more people. But the
process does not end here. The
entrepreneurs and workers in such industries, in which investment has been made,
also spend their newly obtained income which results in increasing output and
employment opportunities. In this
way, we see that the total employment so generated is many times more than the
government employs 300,000 persons on public works and, as a result of increase
in consumer goods, 600,000 more persons get employment in the concerned
industries. In this way, 900,000
persons have been able to get employment, that is, three times more people are
now employed. In other words,
Kahn’s employment multiplier means that by the government undertaking public
works many more times total employment is provided as compared with initial
Income or Investment Multiplier:
multiplier tells us that a given increase in investment ultimately creates total
income which is many times the initial increases in income resulting from that
investment. That is why it is
called income multiplier or investment multiplier.
Income multiplier indicates how many times the total income increases by
a given initial investment.
Suppose Rs. 100
million are invested in public works and as a result there is an increase of Rs.
300 million in income. In this
case, income has been increased 3 times, i.e., the multiplier is 3.
If ΔI represents increase in investment, ΔY indicates increase
in income and K is the multiplier, then the equation of multiplier is as
The multiplier is the
numerical co-efficient showing how large an increase in income will result from
each increase in investment. The
multiplier is the number by which the change in investment must be multiplied in
order to get the resulting change in income.
It is the ratio of change in income to the change in investment.
If an investment of Rs. 50 million increases income by Rs. 150 million,
the income multiplier is 3 and if Rs. 200 million, the multiplier is 4 and so
In the following
multiplier equation, the relationship between income and investment is
determined through marginal propensity to consume:
Propensity to Save)
Therefore, the third
multiplier equation is:
It should be noted
that the size of multiplier varies directly with the size of mpc. When the mpc is high, the multiplier is high and when the mpc
is low, the multiplier is also low.
The multiplier works
not only in money terms but also in real terms.
In other words, the increase in income takes place not only in the form
of money but in the form of goods and services.
mpc is ¾
investment is Rs. 1,000 million
(b) Marginal propensity to save,
(c) Increase in the level of national income, and
mps and multiplier (K):
theory is also very helpful in the determination of national income. In his book, ‘General Theory of Employment, Interest and
Money’, he has contradicted the viewpoint of the classical economists.
He is of the opinion that if an economy operates at a level of
equilibrium it is not necessary that there should be a high level of employment
in a country. It is just possible
that there may be millions of people unemployed.
So according to Keynes, if any country wishes to achieve level of
employment, it can only do so through the changes in the magnitude of
Keynes’ theory, there are two main methods of measuring the equilibrium level
of NI, i.e.:
The AD-AS Approach, and
The Saving Investment Approach
(a) AD-AS Approach: For explaining the determination of level of income in a two-sector economy, we assume an economy in which there is no international trade, no government role and in which corporations retain no earnings. In this simplest model of economy, the level of income is determined at a point where the AD intersects the AS. It is depicted as below:
the above diagram, the national income is determined at the point where AD curve
(C+I) cuts the AS curve (C+S), i.e., at E.
The multiplier effect is also shown in this diagram.
The curve C represents the mpc which is assumed to be ½.
That is why the slope of curve C is 0.5.
Since the AD curve (C + I) cuts the 45o angle line at E, OY1
is the level of income determined. If
now investment is increased to EH (ΔI) we can find out the increase in
income (ΔY). As a result of
investment EH, the AD curve shifts upwards to C + I’.
This new AD curve cuts the AS curve (45o angle line) at F, so
that OY2 income is determined. Thus,
income increases by Y1Y2 as a result of investment
increase of EH, which (Y1Y2) is double of EH.
is clear, therefore, that the multiplier is 2.
It is also calculated as below:
(a) Saving-Investment Approach: In order to simplify the analysis of income determination we imagine an economy (1) where there are no taxes levied by the government, (2) the corporations retain no earnings, and (3) there are no changes in the level of prices. The equilibrium level of NI is determined at a point where planned or intended saving is equal to planned or intended investment, or in other words, where the saving intersect the investment. It is further explained with the help of following diagram:
above diagram shows the multiplier effect of an increase in investment on the
equilibrium level of income. SS is
the supply curve and II is the investment curve showing the total level of
investment of OI. These two curves
intersect each other at the equilibrium point E where is income is OY1.
If now there is a change in
investment from OI to OI’, i.e., an increase of II’, then the II curve will
shift to the position of I’I’ and the two curves I’I’ and SS intersect
each other at the new equilibrium point E’, where the income is OY2.
Now it is clear that when mps is ½, an increase in investment by II’
(let say Rs. 10 million) has led to the increase in income by Y1Y2
(let say Rs. 30 million). Obviously
the value of the multiplier is equal to 3.
Efficiency of production:
If the production system of the country cannot cope with increased demand for
consumption goods and make them readily available, the incomes generated will
not be spent as visualised. As a
result, the mpc may decline.
investment: The value of the multiplier will
also depend on regularly repeated investments.
A steadily increasing investment is essential to maintain the tempo of
period: Successive doses of investment must be
injected at suitable intervals if the multiplier effect is not to be lost.
employment ceiling: As soon as full employment
of the idle resources is achieved, further beneficial effect of the multiplier
will practically cease.
of Income Stream and Their Effect on the Multiplier:
As we know that as income increases, consumption does not increase to the same extent or proportionately, because a part of the income is saved. The part of the income that is saved is as if a leakage from the flow of income stream. These leakages obstruct the growth of national income. In the absence of these leakages, mpc would have been unity. The consumption expenditure would have increased 100 per cent of the increase in income and there would have been full employment. The following are the principal leakages:
debts: It generally happens that a person has
to pay a debt to a bank or to another person.
A part of his income goes out in repaying such debts and is not utilised
either in consumption or in productive activity.
Income used to pay off debts disappears from the income stream.
If, however, the creditor uses this amount in buying consumer goods or in
some productive activity, then this sum will generate some income, otherwise
balances: It is well known that people keep
with them ready cash which is neither used productively nor in purchasing
consumer goods. Keynes has
mentioned three motives for holding ready cash for liquidity preference, viz.,
transactions motive, precautionary motive and speculative motive.
This means that the re-spent part of income goes on decreasing.
In this way, a part of the initial expenditure leaks out of the income
The part of the money spent by country for importing goods also leaks out of the
country’s income stream. It does
not encourage or support any business or industry in the country.
This is specially so if the imports do not help the trade and industry of
the country or if they are not used for export promotion.
The net import is a leakage.
existing securities: Some people purchase
securities (saving certificates) from others and the seller of securities can
hoard this money. This money also
leaks out of the income stream. This
may also be valid in case of purchase of shares, debentures, bonds, insurance
policy, or some other financial investment.
If this invested money is not used in productive areas, there will be a
leakage in the income stream.
inflation: Inflationary situation is also
responsible for leakage. In such a
situation, investment does not help in generating employment or increasing
income. If there is already full
employment in the country, increase in investment, far from increasing demand
for consumer goods, it decreases it as a result of which employment in the
consumer goods industries contracts and demand for capital goods decreases.
Whatever increase in income there is, it is spent in high prices and it
does not help in creating income and employment.
As a result of
leakages of income from the main income stream of the country, the multiplier
effect of the primary or initial investment in increasing income is reduced. If somehow these leakages are plugged, the multiplier effect
of investment in generating income and employment would increase.
If they cannot be plugged altogether, they should be reduced or the
propensity to consume should be increased or propensity to save should be
reduced, otherwise the new investment will not have full effect in increasing
income and employment.
of multiplier has a great role in removing the Great Depression of 1929-34. These days governments are actively interfere in the economic
affairs of the community through multiplier.
Its importance is further explained as below:
1. The multiplier principle focuses on the importance of public investment, which is the key to remove unemployment during the days of depression. An investment of Rs. 1 million can create income and employment worth many times, and can help the government to remove unemployment from the country.
days of depression, the private entrepreneurs are discouraged to invest in the
economy. Therefore, to fill this
gap, the government comes forward and undertakes the investment in
her own hands. Hence, the demand
for consumer goods increases and also the level of NI and employment increases
on account of the working of the multiplier.
demand for goods increases and incomes rise owing to government investment, the profit
expectations of the entrepreneurs go up and as a result the MEC rises.
government makes investment in public works to fight depression and
unemployment, private investment is encouraged on account of the
operation of the multiplier. The
confidence of private investors is restored, and hence helps in further removing
the economic depression of the country.
The following certain
essential conditions / assumptions for the operation of multiplier:
on Keynes’ Multiplier Theory:
including the classical economists and the economists from third world countries
have strongly criticise the Keynes’ Multiplier Theory.
It is explained in brief as below:
describes the relationship between investment and income, i.e., the effect of
investment on income. The
multiplier concept is concerned with original investment as a stimulus to
consumption and thereby to income and employment.
But in this concept, we are not concerned about the effect of income on
investment. This effect is covered
by the ‘accelerator’. The
term ‘accelerator’ should not be confused with the accelerator in
cars. It does not make the
investment to grow faster and faster.
The term ‘accelerator’
is associated with the name of J.M. Clark in the year 1914.
it has been proved a powerful tool of economic analysis since then.
Keynes, astonishingly, has altogether ignored this concept.
That is why, the concept of accelerator is not considered the part of
principle of accelerator, when income increases, people’s spending power
increases; their consumption increases and consequently the demand for consumer
goods increases. In order to meet
this enhanced demand, investment must increase to raise the productive capacity
of the community. Initially,
however, the increased demand will be met by over-working the existing plants
and machinery. All this leads to
increase in profits which will induce entrepreneurs to expand their plants by
increasing their investments. Thus
a rise in income leads to a further induced investment.
The accelerator is the numerical value of the relation between an
increase in income and the resulting increase in investment.
in Rs. ‘000)
– 2 machines
per machine: Rs. 300,000 per machine
In the above example,
suppose we are living in a world, where the only commodity produced is cloth.
Further suppose that to produce cloth Rs. 100,000, we require one machine
worth Rs. 300,000, which means that the value of the accelerator is 3 (i.e., the
capital-output ratio is 1:3). That
is, if demand rises by Rs. 100,000, additional investment worth Rs. 300,000
takes place. If the existing level of demand for cloth remains constant,
let us say, at Rs. 500,000, then to produce this much cloth we need five
machines worth Rs. 1.5 million. At
the end of one year, let us suppose, that one machine becomes useless as a
result of wear and tear, so that at the end of one year, a gross investment of
Rs. 300,000 must take place to replace the old machine in order that the stock
of capital is capable of producing output worth Rs. 500,000.
In the third period,
i.e., the year 2009, demand rises to Rs. 800,000. To produce output worth Rs.
800,000, we need 8 machines. But
our previous stock consisted of only 5 machines.
Thus if we are to produce output worth Rs. 800,000, we must install 3 new
machines, worth Rs. 900,000. The
net investment for the year 2009 will be Rs. 900,000 and with the replacement
cost of one machine Rs. 300,000, our gross investment jumps from Rs. 300,000 in
the year 2008 to Rs. 1.2 million in the year 2009.
A 60 per cent increase in demand led to a 400 per cent increase in gross
investment. Here we have a glimpse
of the powerful destabilising role of accelerator.
of the Accelerator: