After studying this topic, you should be able to understand
In Chapter 5, we had focused on the determination of equilibrium income and output in a simple two sector economy. In this chapter, we will anaylse the changes in the equilibrium income and output in a two sector model.
A change in the equilibrium income or output is the result of a shift in the aggregate demand (or aggregate spending) function or the C + I curve. The aggregate demand curve can either shift upwards or downwards. The amount of the change in the income will be a multiple of the amount of the shift in the aggregate demand curve. The multiplier is the amount by which there is a change in equilibrium income or output when autonomous aggregate expenditure (for example, autonomous investment) increases by one unit. It is this multiplier mechanism that has been discussed in the chapter. We also focus on the conditions necessary for the multiplier to work. The applicability of the multiplier to the less developed countries has also been examined in this chapter.
The multiplier can be defined as the amount by which there occurs a change in the equilibrium level of income due to a change in autonomous aggregate expenditure by one unit.
In a two sector economy, the aggregate demand is a sum of consumption and investment expenditures. It is generally agreed that though both consumption and investment functions undergo a change from one period to another, the consumption function is relatively more stable than the investment function. Thus, the initial changes in income occur more due to the shifts in the investment function. This implies that in the Figure 6.1 it is not the consumption function or the saving function which shifts up and down, it is the investment function which shifts up and down and is responsible for the shift in the C + I curve. Hence, our analysis will be in terms of the shift in the investment function (though the same analysis will apply for a shift in the consumption function).
Figure 6.1 Effect of a Change in Investment on the Equilibrium Income or Output
where, | x-axis = income (or output) |
y-axis = aggregate demand, AD | |
C = consumption function | |
I = investment function | |
ΔI = change in investment | |
S = saving function | |
Y = C + S is the guideline or the 45 degree line |
In Figure 6.1(a) suppose that initially the C + I function intersects the guideline to determine the equilibrium at point El with the equilibrium level of income at Y1. The same can be illustrated in Figure 6.1(b) where the saving function intersects the I function to determine the equilibrium at point E1 with the equilibrium level of income at Y1.
Assume that due to an improvement in the business expectations, there is a permanent increase in investment expenditures per time period by an amount equal to ΔI at all the levels of output. In Figure 6.1(a), this shift has been illustrated by a shift in the C + I curve to C + I + ΔI whereas in Figure 6.1(b), the same shift has been illustrated by a shift in the I curve to the I + ΔI curve. In both the figures, the new equilibrium will be at point E2 with the equilibrium level of income at Y2.
It is of extreme importance to note that an increase in the income from Y1 to Y2 (national income) can occur if and only if the economy is operating at less than full employment. Otherwise, there cannot be an increase in the income.
One would expect that the increase in income from Y1 to Y2, say ΔY would be by the same amount as the increase in the investment expenditures, that is ΔI or that ΔY = ΔI. However, one finds that the increase in income is much more than the increase in investment expenditure which was responsible for bringing about that increase in the income, or in other words ΔY > ΔI. In fact, ΔY = m ΔI where m is what is known as the investment multiplier and has a value greater than 1. Thus,
or
The multiplier can be defined as the amount by which there occurs a change in the equilibrium level of income due to a change in autonomous aggregate expenditure by one unit.
Suppose the economy is initially in equilibrium. Let there be an increase in autonomous investment by Rs. 1 million (ΔI). If the economy is operating at less than full employment, this will be matched by an increase in production and output equal to Rs. 1 million to meet the increased demand. The increase in the production will lead to an equal increase in the income of Rs. 1 million (ΔI) in the form of wages, interest and profits. This is the first round of income generation due to the additional investment of Rs. 1 million.
Those who receive the additional income will consume only a part of it, depending on their marginal propensity to consume, and will save the rest of this income. Suppose the marginal propensity to consume, or b, is 0.8. Hence, they will spend Rs. 1 million × 0.8 = 0.80 million (or b × ΔI = b ΔI) on the consumer goods and services and save Rs. 0.20 million. Thus in the second round, there is an increase in consumption and expenditure by Rs. 0.80 million (or b ΔI). Again production and income will increase to match the increase in the expenditure.
This will lead to a third round of induced expenditures by the recipients of the income in the second round. There will be an increase in consumption and expenditure by Rs. 0.80 million × 0.8 = Rs. 0.64 million (or b ΔI × b = b2ΔI). Hence, an additional income of Rs. 0.64 million is generated in the third round.
It is important to note that the additional income generated in the second round, Rs. 0.80 million (b ΔI), is certainly less than the additional income generated in the first round, Rs. 1 million (ΔI). Similarly the additional income generated in the third round, Rs. 0.64 million (b2ΔI), is less than the additional income generated in the second round, 0.80 million (b ΔI). Thus, the induced expenditures in the second round are smaller than those in the first round whereas those in the third round are smaller than those in the second round. Thus the induced expenditures and, thus, the additional income generated in each round go on becoming smaller and smaller. The rounds of income generation will continue till the additional income generated falls to zero.
The total increase in the income in all the rounds can be summed up as
This is a geometric series and can be put in a simpler form as follows:
Multiplying both sides of Eq. (3) by b, we get
Subtracting Eqs. (4) from (3), we get
ΔY − bΔY = ΔI(1 + b + b2 + b3 + … + bn−1) − ΔI(b + b2 + b3 + b4 + … + bn)
ΔY(1 − b) = ΔI(1 − bn)
Thus,
If the multiplier process continues for a very long period, the value of n will become very large and bn (b is a fraction with its value between zero and one) will approach zero. Hence,
Where m is the investment multiplier. Thus, we have
or
(as b is the marginal propensity to consume)
Table 6.1 depicts the working of the multiplier.
The equilibrium level of income is
Let there be an increase in autonomous investment by ΔI. This will result in an induced increase in income, which will lead to an increase in consumption, or ΔC. Thus, now the equilibrium level of income will be
Subtracting Eq. (8) from Eq. (9), we get
But the consumption function is C = Ca+ bY.
Table 6.1 The Working of the Multiplier
Round | Increase in Aggregate Demand (or Aggregate Expenditure) |
Total Increase in Income |
---|---|---|
1 | ΔI | ΔI |
2 | bΔI | ΔI + bΔI = ΔI(1 + b) |
3 | b2ΔI | ΔI + bΔI + b2ΔI = ΔI(1 + b + b2) |
4 | … | … |
… | … |
Substituting for ΔC from Eq. (11) in Eq. (10), we get
ΔY = bΔY + ΔI
or,
ΔY(1 − b) = ΔI
or,
or,
, where m is the investment multiplier.
It is obvious that the value of the multiplier depends on b, the marginal propensity to consume. The larger the marginal propensity to consume the larger will be the multiplier. When the marginal propensity to consume is 0.5, the multiplier is 2 and when the marginal propensity to consume increases to 0.9, the multiplier increases to 10.
The importance of the multiplier is more obvious in a three sector and a four sector economy. However, it plays an important role even in a two sector economy in that it helps in evaluating the eff ects of an increase in the investment on the national income. Thus, it is able to determine the investment that would be required for a certain planned growth in the national income. Hence, the multiplier is of great importance in planning the economic growth of a nation.
In spite of its utility in economic planning, the multiplier has certain limitations which may prevent it from working. They are as follows:
These limitations do not in any way undermine the importance of the multiplier. In fact, due to these limitations economists have time and again modified the multiplier which has further enhanced its utility in analysing the changes in income in response to an increase in the aggregate demand.
In the article ‘Investment, Income and the Multiplier in an Underdeveloped Economy’ in the Indian Economic Review, February 1953, Dr V. K. R. V. Rao raised doubts regarding the applicability of the multiplier principle to the less developed countries.
The less developed countries (LDCs) have a lower per capita income as compared to the other countries. It is also an established fact that at low levels of income, the marginal propensity to consume is always high. According to the Keynesian theory, the higher the b or the marginal propensity to consume the higher is the value of the multiplier [m = 1/(1 – b)]. Thus, it is to be expected that the multiplier should apply with a stronger effect in LDCs as compared to the developed countries of the world. This would imply that even a small increase in the investment in the LDCs would result in an increase in the income and output, which would be much larger than the increase in the income and output experienced in the developed countries. However, this does not seem to be the case. The reason for this, according to Dr V. K. R. V. Rao, is that the conditions necessary for the multiplier principle to work do not exist in the LDCs. They are satisfied only in the developed countries.
The conditions necessary for the multiplier principle to work are as follows:
The type of unemployment most predominant in these countries is what is known as disguised unemployment. This is a type of unemployment, which is most prevalent in agriculture in a country like India where there exist plots of land on which the whole family may be employed. The additions to the total output and the income by the last few units of labour employed may actually be zero. Yet they continue to till the land simply because they are not aware that they are actually not contributing to the total output. Hence, their unemployment is a kind of concealed one of which even they themselves are not aware. The existence of this disguised unemployment prevents the working of the multiplier principle in the LDCs.
It was widely believed, especially by the classical economists, that saving or thrift was a ‘virtue’ for not only an individual but also for an economy. An individual has to refrain from consumption if he wishes to save. By saving, he is able to amass huge amounts of wealth. Similarly, it was believed that an economy could become rich if every individual in the economy became thrifty.
Keynes, in his General Theory, criticized these beliefs. He argued that what applies to an individual was not necessarily true for the economy. Contrary to the popular beliefs at that time Keynes argued that if the whole economy becomes thrifty, or in other words starts saving more, there will be a decrease in the total consumption in the economy. Hence there will be a decrease in the aggregate demand, and thus the income and output will decrease. As saving is a function of income, a decrease in income will ultimately lead to a decrease in the savings. This is what Keynes called the paradox of thrift. It is a contradiction in that what is good for an individual is not good for an economy.
Figure 6.2 Paradox of Thrift
where, | I | = Investment demand schedule where I is assumed to be constant at |
S1 | = Saving schedule where saving is positively related to income. | |
E1 | = The equilibrium point at which the saving schedule, S1 and investment schedule, I intersect. | |
OY1 | = Equilibrium income when equilibrium is at point E1. | |
S2 | = Saving schedule when the economy becomes more thrifty. | |
E2 | = The equilibrium point at which the saving schedule, S2 and investment schedule, I intersect. | |
OY2 | = Equilibrium income when equilibrium is at point E2. |
Figure 6.2 depicts the paradox of thrift. If everyone in the economy becomes thriftier, the saving schedule will shift upwards from S1 to S2. The equilibrium point will move from E1 to E2 whereas the equilibrium income decreases from Y1 to Y2. This lends credence to the paradox of thrift that an increase in the thrift by one individual may be good in that it may help in increasing his fortunes in the long run but if the whole economy becomes thrifty, the economy’s equilibrium income and output may in fact actually decrease, rather than increase!
Some economists describe this process, where through the paradox of thrift there is ultimately a decrease in the economy’s savings, as a reverse multiplier. The increase in savings, by a reduction in consumption expenditures, will lead to a decrease in the aggregate demand. Thus, there will be a decrease in production leading to a decrease in the income which will further lead to a decrease in savings (which are a function of the income level). The economy will finally reach a new equilibrium at which saving is equal to investment. It is imperative to remember that the paradox of thrift will operate only if the increase in the economy’s saving is not accompanied by an increase in the investment. If there is an increase in investment, then there will occur an increase in the income through the multiplier which will lead to additional savings and investment in the economy, rather than a decrease.
where m is the investment multiplier and b is the marginal propensity to consume.
Numerical Problem 1
In an economy, the basic equations are as follows: the consumption function is C = 150 + 0.80Y and investment is = 180 crores. Find
Numerical Problem 2
Suppose in an economy the marginal propensity to consume is 0.75 and the level of autonomous investment decreases by 20 crores. Find
Calculate the value of the investment multiplier when the marginal propensity to consume is (i) 0.85, (ii) 0.70, (iii) 0.60 (iv) 0.40.
Find the effect of a decrease in the equilibrium income when autonomous investment decreases by 30 crores when the marginal propensity to consume is (i) 0.85, (ii) 0.70, (iii) 0.60 (iv) 0.40.
Numerical Problem 4
In an economy, the marginal propensity to consume is 0.50. The level of autonomous investment decreases by 30 crores. Find
Numerical Problem 5
Assume that in a two sector economy, the income is Rs. 500 billion while the marginal propensity to consume is 40%. Suppose the government wants to increase the income to Rs. 800 billion, by an amount of Rs. 300 billion. By how much should the autonomous investment be increased?
Solution 1
Thus,
Y = 150 + 0.80Y + 200
Y − 0.80Y = 150 + 180
0.20Y = 330
Y = 330/0.20
Y = 1650
The equilibrium level of income is 1650 crores.
Thus, now
Y = 150 + 0.80Y + 200
Y − 0.80Y = 150 + 180
0.20Y = 350
Y = 330/0.20
Y = 1750
The equilibrium level of income is 1750 crores.
Solution 2
We know that
But m is the investment multiplier
Also,
Thus, .
Hence, the decrease in autonomous investment causes a decrease in the equilibrium level of income by 80 crores. This effect occurs due to the reverse multiplier.
Therefore, ΔY = Δ C + Δ S
− 80 = Δ C − 20
(As autonomous investment decreases by 20 crores, the saving will also decrease by 20 crores)
Δ C = − 80 + 20 = − 60 crores
Δ C = − 60 crores
The consumption expenditure decreases by 60 crores.
Hence,
Thus,
Δ Y = ΔI m
The decrease in the equilibrium income when autonomous investment decreases by 30 crores is
Solution 4
But m is the investment multiplier.
Also,
Thus,
Hence, the decrease in autonomous investment causes a decrease in the equilibrium level of income by 60 crores.
Therefore,
ΔY = ΔC + ΔS
− 60 = ΔC − 30
(As autonomous investment decreases by 30 crores, the saving will also decrease by 30 crores)
Δ C = − 60 + 30 = − 30 crores
Δ C = − 30 crores
The consumption expenditure falls by 30 crores.
Solution 5
The income level = Rs. 500 billion
The planned income level = Rs. 800 billion
Change in income = ΔY = 800 – 500 = Rs. 300 billion
Thus,
ΔI = Rs. 180 billion
Thus, autonomous investment should be increased by Rs. 180 billion for the income to increase to Rs. 800 billion, an increase in income by Rs. 300 billion.
(a) Y = 720
The equilibrium level of income is 720 crores.
(b) Y = 800
The equilibrium level of income, when planned investment increases from 100 to 120 crores, is 800 crores.
(c) The multiplier effect is 4.
m = 4
(a) Δ Y = 200
The increase in autonomous investment causes an increase in the equilibrium level of income by 200 crores.
(b) Δ C = 160 crores
The consumption expenditure increases by 160 crores.
ΔI = Rs. 80 billion
Autonomous investment should be increased by Rs. 80 billion for a 100 per cent increase in the income level.
(a) Δ Y = –160
The decrease in autonomous investment causes a decrease in the equilibrium level of income by 160 crores. This effect occurs due to the reverse multiplier.
(b) The decrease in investment by 40 crores is the change in the level of autonomous demand.
(c) Δ C = –120 crores
The consumption expenditure falls by 120 crores.
(a) (i) mps = 1 – mpc = 1 – 0.40 = 0.60
(ii) mps = 1 – mpc = 1 – 0.50 = 0.50
(iii) mps =1 – mpc = 1 – 0.80 = 0.20
(iv) mps = 1 – mpc = 1 – 1.0 = 0
(v) mps =1 – mpc = 1 – 0 = 1
(b) (i) m = 1.67
(ii) m = 2
(iii) Nm = 5
(iv) m = ∞
(v) m = 1
(c) (i) ΔY = ΔIm = 40 × 1.67 = 67
(ii) ΔY = ΔIm = 40 × 2 = 80
(iii) ΔY = ΔIm = 40 × 5 = 200
(iv) ΔY = ΔIm = 40 × ∞ = ∞
(v) ΔY = ΔIm = 40 × 1 = 40
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