Leakages of multiplier
Leakages of Multiplier :
Leakages are the potential diversions from the income stream which tend to weaken the multiplier effect of new investment. Given the marginal propensity to consume, the increase in income in each round declines due to leakages in the income stream and ultimately the process of income propagation “peters out”.
The following are the important leakages:
1, Saving Saving is the most important leakage the multiplier process. Since the marginal propensity to consume is less than one, the whole increment in income is not spent on consumption. A part of it is saved which peters out of the income stream and the increase in income in the next round declines.
Thus the higher the marginal propensity to save, the smaller the size of the multiplier and the greater the amount of leakage out of the income stream and vice versa. For instance, if MPS= 1/6, the multiplier is 6, according to the formula K = 1/MPS; and the MPS of 1/3 gives a multiplier of 3.
2. Strong Liquidity Preference: If people prefer to hoard the increased income in the form of idle cash balances to satisfy a strong liquidity preference for the transaction, precautionary and speculative motives, that will act as a leakage out of the income stream. As income increases people will hoard money in inactive bank deposits and the multiplier process is checked.
3. Purchase of Old Stocks and Securities : If a part of the increased income is used in buying old stocks and securities instead of consumer goods, the consumption expenditure will fall and its cumulative effect on income will be less than before. In other words, the size of the multiplier will fall with a fall in consumption expenditure when people buy old stocks and shares.
4. Debt Cancellation: If a part of increased income is used to repay debts to banks, instead of spending it for further consumption, that part of the income peters out of the income stream. In case, this part of the increased income is repaid to other creditors who save or hoard it, the multiplier process will be arrested.
5. Price Inflation : When increased investment leads to price inflation. the multiplier effect of increased income may be dissipated on higher prices. A rise in the prices of consumption goods implies increased expenditure on them. As a result, increased income is absorbed by higher prices and the real consumption and income fall. Thus price inflation is an important leakeage which tends to dissipate increase in income and consumption on higher prices rather than in increasing output and employment.
6. Net Imports: If increased income is spent on the purchase of imported goods it acts as a leakage out of the domestic income stream. Such expenditure fails to effect the consumption of domestic goods. This argument can be extended to net imports when there is an excess of imports over exports thereby causing a net outflow of funds to other countries.
7. Undistributed Profits: If profits accruing to joint stock companies are not distributed to the shareholders in the form of dividend but are kept in the reserve fund, it is a leakage from the income stream. Undistributed profits with the companies tend to reduce the income and hence further expenditure on consumption goods thereby weakening the multiplier process.
8. Taxation : Taxation policy is also an important factor in weakening the multiplier process. Progressive taxes have the effect of lowering the disposable income of the taxpayers and reducing their consumption expenditure. Similarly commodity taxation tends to raise the prices of goods and a part of increased income may be dissipated on higher prices. Thus increased taxation reduces the income stream and lowers the size of the multiplier.
9. Excess Stocks of Consumption Goods: If the increased demand for consumption goods is met from the existing excess stocks of consumption goods there will be no further increase in output, employment and income and the multiplier process will come to a halt till the old stocks are exhausted.
10. Public Investment Programmes : If the increase in income as a result of increased investment is affected by public expenditures, it may fail to induce private enterprise to spend that income for further investment due to the following reasons.
(a) Public investment programmes may raise the demand for labour and materials leading to a rise in the costs of construction so to make the undertaking of some private projects unprofitable.
(b) Government borrowing may, if not accompanied by a sufficiently liberal credit policy on the part of the monetary authority, increase the rate of interest and thus discourage private investment.
(c) Government operations may also injure private investors’ confidence by arousing animosity or fears of nationalisation.
