What is a multiplier? Let's look at water ripples as an example. When you throw a stone into a pond, ripples begin to form. The ripples cause a series of waves to form and spread across the pond, eventually covering the entire surface. This means that waves multiply in size. Similarly, increasing investment in factors of production such as land, labor, capital, or enterprise will alter and change the output.
The multiplier is the proportionality factor that measures how much the dependent variable changes in response to independent variables. Any change in the number, quality, or price of any factor affects the quantity or value of the output. For example, a 10% increase in employment would result in a 10% increase in total output.
Multipliers are also used to calculate how a change in the economy affects a country's living standards. In this sense, multipliers are identical to formulas employed in physics to calculate numbers.
The multiplier is a notion drawn from classical economic theory. The classical theory explains how an economy works and establishes the norms by which it operates. Essentially, classical theory assists economists in determining the extent to which an economic shift affects a country's level of living. This is due to the inclusion of a notion known as multipliers in classical theory, which allowed economists to compute quantitative changes in a country's living standards.
R. F. Kahn initially established the modern concept of the multiplier in his paper "The Relation of Home Investment to Unemployment" in the June 1931 issue of the Economic Journal. The Employment Multiplier was the multiplier used by Kahn. Keynes adopted Kahn's concept and developed the Investment Multiplier.
Investment multiplier
Let Y = C + I +G + X–M = a + b Y + I + G + X–M ------- (i)
Where Y is output, C is consumption, I stand for investment, G is government expenditure, and X - M is net exports.
A multiplier is a mathematical instrument that can be used to calculate any economic change.
Y1= C1+ I1+G + X–M = a + b Y1+ I1+ G + X–M ----(ii) (Since G, X and M are assumed to be constant)
Where Y1 is the change in output, C1 is the change in consumption, I1 stands for the change in investment, G is government expenditure, and X - M is net exports.
From (i) and (ii)
Y1–Y = a + b Y1+ I1+ G + X–M–(a + b Y + I + G + X–M)
or, ΔY = b Y1–b Y+ I1–I
or, ΔY = b (Y1–Y) + (I1–I)
or, ΔY = b ΔY + ΔI
or, ΔY–b ΔY = ΔI
or, ΔY(1–b) = ΔI
or, ΔY/ ΔI = 1/ (1–b)
Because b is the marginal propensity to consume, the multiplier Km must be equal to 1/ (1-b). The multiplier can also be obtained from the marginal propensity to save (MPS), and it is the reciprocal of MPS, Km = 1/MPS.
or, Km = 1/ (1–b) = ΔY/ ΔI
or, Km (Multiplier) = 1/ (1–b) = ΔY/ ΔI
or, Km (Investment Multiplier) = 1/ (1–MPC)
or, Km (Investment Multiplier) = 1/ (1–MPC)
= ΔY/ ΔI
=Change in income/ Change in investment
The multiplier's value is defined by the marginal propensity to consume. The multiplier's value increases as the marginal propensity to consume increases, and vice versa.
The multiplier is always between one and infinity. Since the MPC is always bigger than zero and less than one. Because the MPC is zero if the multiplier is one, the entire increment of income is conserved and nothing is wasted. An infinite multiplier, on the other hand, suggests that MPC is equal to one and that the entire increase in income is spent on consuming. It will quickly lead to full employment in the economy, triggering an endless inflationary spiral. However, this is a rare occurrence. As a result, the multiplier coefficient ranges from one to infinity.
Why should you know the multiplier?
The multiplier is a key term in economics because it explains how changes in spending affect economic activity. The multiplier effect describes how a little change in spending can result in a larger shift in overall economic activity.
The multiplier effect happens when an initial increase in spending leads to a rise in income for those who receive the expenditure, who then spend some of that income on goods and services. This raises the demand for goods and services, which can lead to higher output and employment. The loop continues as more people are working and have more disposable income, resulting in additional increases in output and employment.
Knowing the level of the multiplier can assist policymakers and business leaders in understanding the economic impact of changes in spending. Higher government investment in infrastructure projects, for example, can contribute to an increase in economic activity because greater spending leads to increased income, consumption, and production. Knowing the multiplier size can also assist in determining the most effective approach to utilize fiscal and monetary policy to stabilize the economy and stimulate growth.
In short, understanding the multiplier idea is crucial in estimating the economic impact of various economic measures. It can help policymakers make better decisions on how to utilize fiscal and monetary policy to stabilize the economy and foster growth.
Importance of Multiplier:
The multiplier is a crucial concept in income and employment theory, first introduced by R. F. Kahn and later popularized by John Maynard Keynes. It plays a significant role in understanding how changes in spending can affect overall economic activity. As economist Richard Goodwin stated, "Lord Keynes transformed the multiplier from an instrument for the analysis of road building into one for the analysis of income building...It set a fresh wind blowing through the structure of economic thought." The importance of the multiplier lies in its ability to demonstrate the ripple effects of changes in spending on overall economic activity.
The multiplier theory emphasizes the significance of investment in income and employment theory. In the short term, fluctuations in income and employment are largely caused by changes in the rate of investment. When investment decreases, there is a cumulative decline in income and employment due to the multiplier process. Conversely, an increase in investment leads to a cumulative increase in income and employment. This illustrates the importance of investment and explains the process of income propagation.
In addition, the multiplier process also highlights the different stages of the trade cycle. A decrease in investment leads to a recession and eventually a depression, while an increase in investment results in a revival and potentially a boom. As such, the multiplier is considered an essential tool in understanding trade cycles.
The multiplier also contributes to bringing a balance between saving and investment. When there is a disparity between saving and investment, an increase in investment through the multiplier process leads to a rise in income, which in turn increases saving and leads to a balance with investment.
A multiplier is also an important tool for modern states in formulating economic policies. It supports state intervention in economic affairs in order to achieve full employment, control trade cycles, and through deficit financing and public investment. By understanding the multiplier effect on income and employment, states can adjust investment levels to mitigate inflationary or deflationary pressures and promote economic stability. It is important to note that public investment should supplement, not replace, private investment, and that timing is crucial to maximize the multiplier effect.
In short importance of the multiplier is listed below:
- The multiplier highlights the importance of investment in income and employment theory.
- It explains the process of income propagation through fluctuations in the rate of investment.
- It is an indispensable tool in understanding the different phases of the trade cycle.
- It helps to bring equality between saving and investment.
- It is an important tool in the formulation of economic policies, such as achieving full employment, controlling trade cycles, and deficit financing.
- It is particularly important in public investment policy, as it allows the state to create or control income and employment.
- It can be used to supplement private investment, and its timing can be used to maximize its effectiveness.
Leakage of Multiplier:
The multiplier is a concept in macroeconomics that refers to the increase in overall economic activity resulting from an initial injection of spending. However, there are factors that can weaken or "leak" out of the income stream, reducing the overall impact of the multiplier. These factors, known as leakages, include:
Saving: If a portion of the increased income is saved rather than spent, it will not contribute to further economic activity.
Strong liquidity preference: If people hoard money instead of spending it, this will also reduce the multiplier effect.
Purchase of old stocks and securities: If people use their increased income to buy old stocks and securities instead of consumer goods, this will also weaken the multiplier effect.
Debt cancellation: If people use their increased income to pay off debt, this will also reduce the multiplier effect.
Price inflation: If increased investment leads to price inflation, the multiplier effect may be reduced as higher prices absorb some of the increased income.
Net imports: If increased income is spent on imported goods, this will not contribute to domestic economic activity.
Undistributed profits: If companies keep profits in reserve instead of distributing them, this will also reduce the multiplier effect.
Taxation: Progressive taxes and commodity taxes can reduce disposable income and consumption expenditure, weakening the multiplier effect.
Excess stocks of consumption goods: If increased demand for goods is met from existing stocks, this will not lead to further increases in output, employment, and income.
Public investment programs: Public investment programs can raise costs, discourage private investment, and reduce private investors' confidence, which can also weaken the multiplier effect.
