Concept of Multiplier
Keynes considers his theory of multiplier as an integral part of his theory of employment. The multiplier, according to Keynes, “establishes a precise relationship, given the propensity to consume, between aggregate employment and income and the rate of investment. It tells us that, when there is an increment of investment, income will increase by an amount which is K times the increment of investment” i.e., AY KAL
In the words of Hansen, Keynes’ investment multiplier is the coefficient relating to an increment of investment to an increment of income, i.e., K-AY AI, where Y is income, I is investment. A is change (increment of decrement) and K is the multiplier. In the multiplier theory, the important element is the multiplier coefficient,
K which refers to the power by which any initial investment expenditure is multiplied to obtain a final increase in income. The value of the multiplier is determined by the marginal propensity to consume. The higher the marginal propensity to consume, the higher is the value of the multiplier and vice versa.
Working of the Multiplier:
The multiplier works both forward and backward. First, we study its forward working. The multiplier theory explains the cumulative effect of a change in investment on income via its effect on consumption expenditure.
Forward Operation:
We first take the “sequence analysis” which shows a “motion picture” of the process of income propagation. An increase in investment leads to increased production which creates income and generates consumption expenditure. This process continues in dwindling series till no further increase in income and expenditure is possible. This is a legless instantaneous process in a static framework, as explained by Keynes. Suppose that in an economy MPC is 1/2 and investment is raised by Rs 100 crores. This will immediately lead to a rise in production and income by Rs 100 crores. One-half of this new income will be immediately spent on consumption goods which will lead to increase in production and income by the same amount and so on. The process is set out in Table II. It reveals that an increment of Rs 100 crores of investment in the primary round leads to the same increase in income. Of this, Rs 50 crores are saved and Rs 50 crores are spent on consumption which go to increase income by the same amount in the second round.
This dwindling process of income generation continues in the secondary rounds till the total income generated from Rs 100 crores of investment rises to Rs 200 crores. This is also clear from the multiplier formula, AY-KA1 or 200-2×100, where K-2 (MPC-1/2) and AI-Rs 100 crores.
This process of income propagation as a result of increase in investment.
The C curve has a slope of 0.5 to show the MPC equal to one-half. C+ I is the investment curve which intersects the 45° line at E, so that the old equilibrium level of income is OY,. Now there is and increase in investment of A las shown by the distance between C+I and C+I+A I curves. This curve intersects the 45° line at E, to give OY, as the new income. Thus the rise in income Y, Y, as shown by AY is twice the distance between C+ I and C+1+AL since the MPC is one-half.
The same results can be obtained if MPS is taken so that when income increases, saving also increase to equal the new investment at a new equilibrium level of income. This is shown in Figure 12. S is the savig function with a slope of 0.5 to show MPS of one-half. I is the old investment curve which cuts S at E; so that OY, is the old equilibrium level of income.
The increase in investment A1 is superimposed on the At curve in the shape of a new investment curve I Alwhich is intersected by the S curve at E, to give OY, as the new equilibrium level of income. The rise in income Y Y, (shown as AV) is exactly double the increase in investment AL as the MPS is one-half Backward Operation:
The above analysis pertains to the forward operation of the multiplier. If. however, investment decreases, instead of increasing, the multiplier operates backward. A reduction in investment will lead to contraction of income and consumption which, in turn, will lead to cumulative decline in income and consumption till the contraction in aggregate income is the multiple of initial decrease in investment.
Suppose investment decreases by Rs 100 crores. With an MPC -0.5 and K-2, consumption expenditure would keep on declining till aggregate income is increased by Rs 200 crores. In terms of multiplier formula. A Y-K(-A), we get-200-2(-100)
The magnitude of contraction due to the backward operation of the multiplier depends on the value of MPC. The higher the MPC, the greater is the value of multiplier and the greater the cumulative decline in income. and vice versa. On the contrary, the higher the MPS, the lower is the value of the multiplier and the smaller the cumulative decline in income and vice versa.
Thus, a community with a high propensity to consume (or low propensity to save) will be hurt more by the reverse operation of the multiplier than one with a low propensity to consume (or high propensity to save).
Diagrammatically, the reverse operation also can be explained in terms of Figures 11. and 12. when investment decreases, the investment function C+I+AI Shifts downward to C+LAs a result, the equilibrium level also shifts from E, to E, to and income declines from OY, to OY
The MPC being 0.5, the fall in income Y, Y, is exactly double the decline in investment as shown by the distance between C+1+AI and C+L Similarly, in Figure 12 when investment falls, the investment function 1 + A shifts downward as I curve and income decreases from OY, to OY The MPS being 0.5, the decrease in income YY, is double the decline in investment as measured by the distance between 1+ Aland I curves.
Criticism of Multiplier:
The multiplier theory has been severely criticised by the post Keynesian economists on the following grounds:
1. Merely Tautological Concept: Prof. Haberler has criticised Keynes’ multiplier as tautological. It is a truism which defines the multiplier as necessarily true as K-1/1-ACAY pointed by Professor Hansen, “Such a coefficient is a mere arithmetic multiplied i.e., a truism) and not a true behaviour multiplier based on a behaviour pattern which establishes a verifiable relation between consumption and income. A mere arithmetic multiplier, 1/1 = ACAY is tautological.”
2. Timeless Analysis: Keynes’s logical theory of the multiplier is an instantaneous process without time lag. It is a timeless static equilibrium analysis in which the total effect of a change in investment on income is instantaneous so that consumption goods are produced simultaneously and consumption expenditure is also incurred instantaneously.
But this is not borne out by facts because a time lag is always involved between the receipt of income and its expenditure on consumption goods and also is producing consumption goods. Thus “the timeless multiplier analysis disregards the transition and deals only with the new equilibrium income level” and is therefore unrealistic.
3. Worthless Theoretical Toy: According to Hazlitt, the Keynesian multiplier “is a strange concept about which some Keynesians make more fuss than about anything else in the Keynesian system.” It is a myth for there can never by any precise, predeterminable or mechanical relationship between investment and income. Thus he regards it as “a worthless theoretical toy.”
4. Acceleration Effect Ignored: One of the weakness of the multiplier theory is that it studies the effects of investment on income through changes in consumption expenditure. But if ignores the effect of consumption on investment which is known as the acceleration principle. Hicks, Samuelson and others have shown that it is the interaction of the multiplier and the accelerator which helps in controlling business fluctuations.
5. MPC does not Remain Constant: Gordon points out that the greatest weakness of the multiplier concept is its exclusive emphasis on consumption. He favours the use of the term ‘marginal propensity to spend’ in place of marginal propensity to consume to make this concept more realistic.
He also objects to the constancy of the marginal propensity to spend (or consume) because in a dynamic economy, it is not likely to remain constant. If it is assumed to be constant, it is not possible “to predict with much accuracy the multiplying effects over the cycle of a given increase in private investment or public spending.”
6. Relation between Consumption and Income: Keynes’s multiplier theory establishes a linear relation between consumption and income with the hypothesis that the MPC is less than one and greater than zero. Empirical studies of the behaviour of consumption in relation to income show that relationship between the two is complicated and non-linear.
As pointed out by Garnder Ackley, “The relationship does not run simply from current consumption, but rather involves some complex average of past and expected income and consumption. There are other factors than income to consider.”
Other economists have not been lagging behind in their criticism of the multiplier concept. Prof. Hart considers it “a useless fifth wheel.” To Stigler, it is the fuzziest part of Keynes’s theory. Prof. Hutt calls it a “rubbish apparatus” which should be expunged from text books.
But despite its scathing criticism, the multiplier principle has considerable practical applicability to economic problems.
