Effects of investment Multiplier on change in income and output

The Keynesian Multiplier is an economic theory that asserts that an increase in private consumption expenditure, investment expenditure, or net government spending (gross government spending government tax revenue) raises the total Gross Domestic Product (GDP) by more than the amount of the increase. Therefore, if private consumption expenditure increases by 10 units, the total GDP will increase by more than 10 units.

Components of the Keynesian Theory

The three main components of the Keynesian Theory are:

• Aggregate demand is influenced by the decisions in the private and public sector. The level of demand by the private sector could exert an effect on macroeconomic conditions. For example, a decrease in aggregate spending can bring the economy into a recession. However, the negative impact of private decision-making can be mitigated through government intervention with a fiscal or monetary stimulus.
• Prices such as wages are often slow to respond to changes in demand and supply. It is why there are many instances of a shortage or an excess in the supply of labor.
• A change in aggregate demand causes the greatest impact on the output and employment in the economy. Keynesian economic theory says that spending by consumers and the government, investment, and exports will increase the level of output. Even a change in one the components will cause total output to change.

Calculating the Keynesian Multiplier

The value of the multiplier depends on the marginal propensity to consume and the marginal propensity to save.

1. Marginal Propensity to Save

The change in total savings as a result of a change in total income is known as the marginal propensity to save. When an individual’s income increases, the marginal propensity to save (MPS) measures the proportion of income the person saves rather than spend on goods and services. It is calculated as MPS = ΔS / ΔY.

2. Marginal Propensity to Consume

The change in total consumption as a result of a change in total income is known as the marginal propensity to consume. The marginal propensity to consume (MPC) measures how consumer spending changes with a change in income. Using the figures above, the MPC is ΔC / ΔY = 300/600 = 0.5.

Leakages in the Multiplier Process:

We have seen above that as a result of increase in investment, the level of income increases by a multiple of it. In our above analysis, saving is a leakage in the multiplier process. Had there been no saving and as a result marginal propensity to consume were equal to 1, the multiplier would have been equal to infinity.

In that case as a result of some initial increase in investment, income would go on rising indefinitely. Since marginal propensity to consume is actually less than one, some saving does take place. Therefore, multiplier in actual practice is less than infinity.

But besides saving, there are other leakages in the process of income generation which reduce the size of the multiplier. Therefore, the increase in income as a result of some increase in investment will be less than warranted by the size of the multiplier measured by the given marginal propensity to consume. We explain below the various leakages that occur in the income stream and reduce the size of multiplier in the real world.

Paying off debts:

The first leakage in the multiplier process occurs in the form of payment of debts by the people, especially by businessmen. In the real world, all income received by the people as a result of some increase in investment is not consumed. A part of the increment in income is used for paying back the debts which the people have taken from moneylenders, banks or other financial institutions.

The incomes used for paying back the debts do not get spent on consumer goods and services and therefore leak away from the income stream. This reduces the size of the multiplier. Of course, when incomes received by the moneylenders, banks or institutions are again lent back to the people, they come back to the income stream and enhance the size of multiplier. But this may or may not happen.

Holding of idle cash balances:

If the people hold apart of their increment in income as idle cash balances and do not use it for consumption, they also constitute leakage in the multiplier process. As we have seen, people keep part of their income for satisfying their precautionary and speculative motives, money kept for such purposes is not consumed and therefore does not appear in the successive rounds of consumption expenditure and therefore reduces the increments in total income and output.

Imports:

In our above analysis of the working of the multiplier process we have taken the example of a closed economy, that is, an economy with no foreign trade. If it is an open economy as is usually the case, then a part of increment in income will also be spent on the imports of consumer goods. The proportion of increments in income spent on the imports of consumer goods will generate income in other countries and will not help in raising income and output in the domestic economy.

Increase in Prices:

Price inflation constitutes another important leakage in the working of the multiplier process in real terms. The multiplier works in real terms only when as a result of increase in money income and aggregate demand, output of consumer goods is also increased.

When output of consumer goods cannot be easily increased, a part of the increases in the money income and aggregate demand raises prices of the goods rather than their output. Therefore, the multiplier is reduced to the extent of price inflation. In developing countries like India the extra incomes and demand are mostly spent on food-grains whose output cannot be increased so easily.

Therefore, the increments in demand raise the prices of goods to a greater extent than the increase in their output. Besides, in developing countries like India, there is not much excess capacity in many consumer goods industries, especially in agriculture and other wage-goods industries.

Therefore, when income and demand increase as a result of increase in investment, it generally raises the prices of these goods rather than their output and therefore weakens the working of the multiplier in real terms. Thus, it was often asserted in the past that Keynesian theory of multiplier was not very much relevant to the conditions of developing countries like India. However, we shall discuss later that this old view about the working of Keynes’ multiplier is not fully correct.

The above various leakages reduce the multiplier effect of the investment undertaken. If these leakages are plugged, the effect of change in investment on income and employment would be greater.

Multiplier with Changes in Price Level:

In our above analysis of multiplier with aggregate demand curve, it is assumed that price level remains constant and the firms are willing to supply more output at a given price. How much national income or GNP increases as a result of any autonomous expenditure such as government expenditure, investment expenditure, net exports is determined by a shift in aggregate demand curve by the size of simple Keynesian multiplier when price level is fixed.

This implies a horizontal short-run supply curve. However, as studied above, short-run aggregate supply curve slopes upward as the firms are willing to supply additional output in the short run only at a higher price level. With short-run aggregate supply curve sloping upward, a rightward shift in aggregate demand curve raises new equilibrium GNP level not equal to the horizontal shift in the aggregate demand curve but less than it.

Consequently, the size of multiplier is smaller than that of simple Keynesian multiplier with a given fixed price level. This is because a part of expansionary effect of GNP of the increase in autonomous government expenditure is offset by rise in the price level.

The multiplier effect in case of upward sloping curve is shown in Fig. 10.3. To begin with, in the top panel of Fig. 10.3 aggregate expenditure curve AE₀ intersects 45° line at point Sand determines Y₀ equilibrium level of GNP. In the panel at the bottom of Fig. 10.3 the corresponding aggregate demand curve AD₀ and the short-run aggregate supply curve SAS intersect at B’ at the above determined GNP level K₀. Now suppose autonomous investment expenditure (which is independent of changes in price level) increases by AI.

As a result, aggregate expenditure curve AE shifts upward to AE₁ and determines new equilibrium GNP level equal to Y₂. In the lower panel (b), due to the upward shift in aggregate expenditure curve, aggregate demand curve shifts rightward from AD to AD₁The horizontal shift in the aggregate demand curve at a given price level is determined by the increase in aggregate expenditure multiplied by the simple Keynesian multiplier at the given fixed price level (B’H or ∆Y = ∆I 1/1- MPC) But given the upward sloping short-run aggregate supply curve SAS with new aggregate demand curve AD₁, price level does not remain fixed. As will be seen from the lower panel (b) of Fig. 10.3, the aggregate demand curve AD₁ intersects the short-run aggregate supply curve SAS at point R’ and as a result price level rises to P₁.

Now, with this rise in price level to P₁, aggregate expenditure curve in the upper panel (a) will not remain unaffected but will shift downward. This fall in aggregate expenditure curve is due to the adverse effects on wealth or real balances, interest rate and net exports. Much of wealth is held in the form of bank deposits, bonds and shares of companies and other assets.

With the rise in price level, real value or purchasing power of wealth possessed by the people declines. This induces them to spend less. As a result, consumption expenditure declines due to this wealth effect. Secondly, the rise in price level reduces the supply of real money balances (M^s/P) that causes a shift in money supply curve to the left.

Given the demand function for money (M^d), the decline in the real money supply will cause rate of interest to rise. Now, the rise in interest will induce private investment expenditure to decline. Lastly, rise in price level in the domestic economy will adversely affect exports of a country causing net exports to fall.

Thus, as a result of negative effects of rise in price level on real wealth, private investment and net exports, in the upper panel (a) of Fig. 10.3 aggregate expenditure curve shifts downward to AE₁ (dotted) so that it determines GNP level Y₁ at which aggregate expenditure curve AE₁ intersects 45° line. This also corresponds to the intersection of aggregate demand curve AD₁ and short-run aggregate supply curve SAS point R’ in the lower panel (b) of Q 1. Fig. 10.3.

Thus with the upward sloping short-run aggregate supply curve SAS, the effect of increase in autonomous investment expenditure (or for that matter increase in any other autonomous expenditure such as Government expenditure, net exports, autonomous consumption) on the GNP level can be visualized to occur in two stages.

First, increase in investment expenditure shifts aggregate expenditure curve AE upward in the upper panel (a) of Fig. 10.3 and correspondingly aggregate demand curve in the lower panel (b) shifts to the right to AD₁ and brings about increase in GNP level from Y₀ to Y₂with the given fixed price level P_r In the second stage due to the upward sloping short-run aggregate supply curve SAS, the rightward shift in the aggregate demand curve causes price level to rise from P₀ to P_t and causes decrease in GNP from Y₂to Y₁

However, as shall be seen from Fig. 10.3, when price level effect is taken into account, the increase in investment expenditure has still a multiplier effect on real GDP but this effect is smaller than it would be if price level remained fixed. It may be further noted that steeper the slope of the short- run supply curve, the greater is the increase in the price level and smaller is the effect on real GNP.

Importance of the Concept of Multiplier:

Multiplier is one of the most important concepts developed by J.M. Keynes to explain the determination of income and employment in an economy. The theory of multiplier has been used to explain the cumulative upward and downward swings of the trade cycles that occur in a free-enterprise capitalist economy. When investment in an economy rises, it has a multiple and cumulative effect on national income, output and employment.

As a result, economy experiences rapid upward movement. On the other hand, when due to some reasons, especially due to the adverse change in the expectations of the business class, investment falls, then backward working of the multiplier causes a multiple and cumulative fall in income, output and employment and as a result the economy rapidly moves on downswing of the trade cycle. Thus, Keynesian theory of multiplier helps a good deal in explaining the movements of trade cycles or fluctuations in the economy.

The theory of multiplier has also a great practical importance in the field of fiscal policy to be pursued by the Government to get out of the depression and achieve the state of full employment. To get rid of depression and remove unemployment, Government investment in public works was recommended even before Keynes.

But it was thought that the increase in income will be limited to the amount of investment undertaken in these public works. But the importance of public works is enhanced when it is realised that the total effect on income, output and employment as a result of some initial investment has a multiplier effect. Thus, Keynes recommended Government investment in public works to solve the problem of depression and unemployment.

The public investment in public works such as road building, construction of hospitals, schools, irrigation facilities will raise aggregate demand by a multiple amount. The multiple increase in income and demand will also encourage the increase in private investment.

Thus, the deficiency in private investment which leads to the state of depression and underemployment equilibrium will now be made up and a state of full employment will be restored. If the multiplier had not worked, the income and demand would have risen as a result of some public investment but not as much as they rise with the multiplier effect.

Inspired by the Keynesian theory of multiplier, expansionary fiscal policy of increase in Government expenditure and reduction in income tax have been adopted by President John Kennedy and President George W. Bush in the United States of America to remove involuntary unemployment and depression. This had a great success in removing unemployment and depression and therefore, Keynesian theory of multiplier was vindicated and as a result people’s belief in it increased.