UNIT-IV

WHAT IS A MULTIPLIER?

In economics, a multiplier broadly refers to an economic factor that, when increased or changed,
causes increases or changes in many other related economic variables. In terms of gross domestic
product, the multiplier effect causes gains in total output to be greater than the change in
spending that caused it.

The term multiplier is usually used in reference to the relationship between government spending
and total national income. Multipliers are also used in explaining fractional reserve banking,
known as the deposit multiplier.

KEY TAKEAWAYS

• A multiplier refers to an economic factor that, when applied, amplifies the effect of some
other outcome.
• A multiplier value of 2x would therefore have the result of doubling some effect; 3x
would triple it.
• Many examples of multipliers exist, such as the use of margin in trading or the money
multiplier in fractional reserve banking.

What's a Multiplier?

Explaining Multipliers
A multiplier is simply a factor that amplifies or increase the base value of something else. A
multiplier of 2x, for instance, would double the base figure. A multiplier of 0.5x, on the other
hand, would actually reduce the base figure by half. Many different multipliers exist in finance
and economics.

The Fiscal Multiplier

The fiscal multiplier is the ratio of a country's additional national income to the initial boost in
spending or reduction in taxes that led to that extra income. For example, say that a national
government enacts a $1 billion fiscal stimulus and that its consumers' marginal propensity to
consume (MPC) is 0.75. Consumers who receive the initial $1 billion will save $250 million and
spend $750 million, effectively initiating another, smaller round of stimulus. The recipients of
that $750 million will spend $562.5 million, and so on.

The Investment Multiplier

An investment multiplier similarly refers to the concept that any increase in public or private
investment has a more than proportionate positive impact on aggregate income and the general
economy. The multiplier attempts to quantify the additional effects of a policy beyond those
immediately measurable. The larger an investment's multiplier, the more efficient it is at creating
and distributing wealth throughout an economy.
The Earnings Multiplier
The earnings multiplier frames a company's current stock price in terms of the
company's earnings per share (EPS) of stock. It presents the stock's market value as a function
of the company's earnings and is computed as (price per share/earnings per share).

This is also known as the price-to-earnings (P/E) ratio. It can be used as a simplified valuation
tool for comparing relative costliness of the stocks of similar companies, and for judging current
stock prices against their historical prices on an earnings relative basis.

The Equity Multiplier

The equity multiplier is a commonly used financial ratio calculated by dividing a company's total
asset value by total net equity. It is a measure of financial leverage. Companies finance their
operations with equity or debt, so a higher equity multiplier indicates that a larger portion of
asset financing is attributed to debt. The equity multiplier is thus a variation of the debt ratio, in
which the definition of debt financing includes all liabilities.

Multiplying Money
One popular multiplier theory and its equations were created by British economist John Maynard
Keynes. Keynes believed that any injection of government spending created a proportional
increase in overall income for the population, since the extra spending would carry through the
economy. In his 1936 book, "The General Theory of Employment, Interest, and Money," Keynes
wrote the following equation to describe the relationship between income (Y), consumption (C)
and investment (I):

The equation states that for any level of income, people spend a fraction and save/invest the
remainder. He further defined the marginal propensity to save and the marginal propensity to
consume (MPC), using these theories to determine the amount of a given income that is invested.
Keynes also showed that any amount used for investment would be reinvested many times over
by different members of society. For example, assume a saver invests $100,000 in a savings
account at his bank.

Because the bank is only required to maintain a portion of that money on hand to cover deposits,
it can loan out the remainder of the deposit to another party. Assume the bank loans out $75,000
of the initial deposit to a small construction company, who uses it to build a warehouse. The
funds spent by the construction company go to pay electricians, plumbers, roofers, and various
other parties to build it.

These parties then go on to spend the funds they receive according to their own interests. The
$100,000 has earned a return for the investor, the bank, the construction company and the
contractors that built the warehouse. Since Keynes' theory showed that investment was
multiplied, increasing incomes for many parties, Keynes coined the term "multiplier" to describe
the effect.
The deposit multiplier is frequently confused, or thought to be synonymous, with the money
multiplier. However, although the two terms are closely related, they are not interchangeable. If
banks loaned out all available capital beyond their required reserves, and if borrowers spent
every dollar borrowed from banks, then the deposit multiplier and the money multiplier would be
essentially the same.

In actual practice, the money multiplier, which designates the actual multiplied change in a
nation's money supply created by loan capital beyond bank's reserves, is always less than the
deposit multiplier, which can be seen as the maximum potential money creation through the
multiplied effect of bank lending.

STATIC DYNAMIC MULTIPLIER

Depending on the purpose of analysis sometimes a distinction is made between the static
multiplier and the dynamic multiplier. The static multiplier is also called comparative static
multiple simultaneous multiplier, logical multiplier, timeless multiplier, legless multiplier and
instant multiplier

The concept of static multiplier implies that changes in investment causes change in income
instantaneously. It means that there is no time lag between the change in investment and the
change in income. It implies that the moment a rupee is spent on investment project, society’s
income increases by a multiple. Let us explain the concept of the dynamic multiplier also known
as period and sequence multiplier.

The concept of dynamic multiplier recognizes the fact that the overall change in income as a
result of the change in investment is not instantaneous. There is a gradual process by which
income change as a result of change in investment or other determinants of income. The process
of change in income involves a time lag. The multiplier process works through the process of
income generation and consumption expenditure. The dynamic multiplier takes into account the
dynamic process of the change in income and the change in consumption at different stages due
to change in investment. The dynamic multiplier is essentially a stage-by stage computation of
the change in income resulting from the change in investment till the full effect of the multiplier
is realized.
 FOREIGN TRADE MULTIPLIER: MEANING, WORKING, ASSUMPTION,

EXPLANATION, EFFECTS AND CRITICISMS!

Meaning:

The foreign trade multiplier, also known as the export multiplier, operates like the investment

multiplier of Keynes. It may be defined as the amount by which the national income of a country

will be raised by a unit increase in domestic investment on exports.

As exports increase, there is an increase in the income of all persons associated with export

industries. These, in turn, create demand for goods. But this is dependent upon their marginal

propensity to save (MPS) and the marginal propensity to import (MPM). The smaller these two

marginal propensities are, the larger will be the value of the multiplier, and vice versa.

It’s working:

The foreign trade multiplier process can be explained like this. Suppose the exports of the

country increase. To begin with, the exporters will sell their products to foreign countries and

receive more income. In order to meet the foreign demand, they will engage more factors of

production to produce more.

This will raise the income of the owners of factors of production. This process will continue and

the national income increases by the value of the multiplier. The value of the multiplier depends

on the value of MPS and MPM, there being an inverse relation between the two propensities and

the export multiplier.

The foreign trade multiplier can be derived algebraically as follows:

The national income identity in an open economy is

Y=C+I+X–M
Where Y is national income, C is national consumption, I is total investment, X is exports and M

is imports.

The above relationship can be solved as:

Y-C = 1 + X-M

or S = I+X-M (S=Y-C)

S+M=I+X

Thus at equilibrium levels of income the sum of savings and imports (S+M) must equal the sum

of investment and export (1+X).

In an open economy the investment component (I) is divided into domestic investment (Id) and

foreign investment (If)

I=S

Id + If = S… (1)

Foreign investment (If) is the difference between exports and imports of goods and services.

If =X-M…. (2)
Substituting (2) into (1), we have

ld+ X-M – S

or Id + X = S+M

Which is the equilibrium condition of national income in an open economy. The foreign trade

multiplier coefficient (Kf) is equal to

Kf = ∆Y/∆X

And ∆X = ∆S + ∆M
It shows that an increase in exports by Rs. 1000 crores has raised national income through the

foreign trade multiplier by Rs. 2000 crores, given the values of MPS and MPM.

It’s Assumptions:

The foreign trade multiplier is based on the following assumptions:

1. There is full employment in the domestic economy.

2. There is direct link between domestic and foreign country in exporting and importing goods.

3. The country is small with no foreign repercussion effects.

4. It is on a fixed exchange rate system.

5. The multiplier is based on instantaneous process without time lags.

6. There is no accelerator.
7. There are no tariff barriers and exchange controls.

8. Domestic investment (Id) remains constant.

9. Government expenditure is constant.

10. The analysis is applicable to only two countries.

Diagrammatic Explanation:

Given these assumptions, the equilibrium level in the economy is shown in Figure 1, where S(Y)

is the saving function and (S+M) Y is the saving plus import function. ld represents domestic

investment and ld + X, domestic investment plus exports. (S+M) Y and Id+ X functions

determine the equilibrium level of national income OY at point E, where savings equal domestic

investment and exports equal imports.

If there is a shift in the Id + X function due to an increase in exports, the national income will
increase from OY to OY1 as shown in Figure 2. This increase in income is due to the multiplier

effect, i.e. ∆Y = Kf ∆X. The exports will exceed imports by sd, the amount by which savings will

exceed domestic investment. The new equilibrium level of income will be OY1. It is a case of

positive foreign investment.

If there is a fall in exports, the export function will shift downward to Id + X1 as shown in Figure

3. In this case imports would exceed exports and domestic investment would exceed savings by

ds. The level of national income is reduced from OY to OY1. This is the reverse operation of the

foreign trade multiplier.

Criticisms of Foreign Trade Multiplier:

The two models of the foreign trade multiplier presented above are based on certain assumptions

which make the analysis unrealistic.

1. Exports and Investment not Independent:

The analysis of simple foreign trade multiplier is based on the assumption that exports and

investment (both domestic and foreign) are independent of changes in the level of national

income. But, in reality, this is not so. A rise in exports does not always lead to increase in

national income. On the contrary, certain imports, of say capital goods, have the effect of

increasing national income.

2. Legless Analysis:

The foreign trade multiplier is assumed to be an instantaneous process whereby it provides the

final results. Thus it involves no lags and is unrealistic.

3. Full Employment not Realistic:

The analysis is based on the assumption of a fully employed economy. But there is less than full

employment in every economy. Thus the foreign trade multiplier does not find clear expression

in an economy with less than full employment.

4. Not Applicable to More than two Countries:

The whole analysis is applicable to a two-country model. If there are more than two countries, it

becomes complicated to analyse and interpret the foreign repercussions of this theory.

5. Neglects Trade Restrictions:

The foreign trade multiplier assumes that there are no tariff barriers and exchange controls. In

reality, such trade restrictions exist which restrict the operations of the foreign trade multiplier.

6. Neglects Monetary-Fiscal Measures:

This analysis is based on the unrealistic assumption that the government expenditure is constant.

But governments always interfere through monetary and fiscal policies which affect exports,
imports and national income. Despite these shortcomings, the foreign trade multiplier is a

powerful tool of economic analysis which helps in formulating policy measures.

THE SUPER-MULTIPLIER OR THE MULTIPLIER-ACCELERATOR

INTERACTION:

In order to measure the total effect of initial investment on income, Hicks has combined the

multiplier and the accelerator mathematically and given it the name of the super-multiplier. The
combined effect of the multiplier and the accelerator is also called the leverage effect which may

lead the economy to very high or low level of income propagation.

The super-multiplier is worked out by combining both induced consumption (cY or ∆C/∆Y or

MPC) and induced investment (v Y or ∆I/ ∆Y or MPI). Hicks divides the investment component

into autonomous investment and induced investment so that investment I = Id + vY, where Ia is

autonomous investment and vY is induced investment.

Where Ks is the super-multiplier, c is the marginal propensity to consume, v the marginal

propensity to invest, and s is the marginal propensity to save (s=1- c).

The super-multiplier tells us that if there is an initial increase in autonomous investment, income

will increase by Ks times the autonomous investment. So the super-multiplier in general form

will be

Let us explain the combined operation of the multiplier and the accelerator in terms of the above
equation. Suppose c = 0.5, v = 0.4 and autonomous investment increases by Rs. 100 crores. The

increase in aggregate income will be

It shows that a rise in autonomous investment by Rs 100 crores has raised income to Rs. 1000

crores. The simple multiplier would have raised income to only Rs. 200 crores, given the value

of K the multiplier as 2 (since MPC = 0.5). But the multiplier combined with the accelerator
(Ks = 10) has raised income to Rs. 1000 crores which is higher than generated by the simple

multiplier.

Table II explains how the process of income propagation via the multiplier and the accelerator

with the value of the super-multiplier Ks = 10 leads to a rise in income to Rs. 1000 crores with an

initial investment of Rs. 100 crores.

In period t+1 constant investment of 100 is injected into the economy but there is no immediate

induced consumption or investment. In period t+2, induced consumption of 50 takes place out of

the income 100 of period t+1, since the marginal propensity to consume is 0.5, while there is an

induced investment of 40 out of 100 income (v being 0.4).

The increase in income from period 1 to 2 is (50+40) = 90. The increase in income in different

periods can be calculated as ∆Yt+2 = c ∆ Yt+1 + v∆Yt+1 = 0.5x 100 + 0.4x 100 = 90. Similarly, the

increase in income in period t+3 can be calculated as ∆Yt+3 = c∆Yt+2 + v ∆Yt+2 =

0.5×90+0.4×90=45+36=81.

The total increase in income (column 6) is arrived at by adding the increase in income (column
5) of the current period to the total increase in income (column 6) of the previous period. For
instance, the total increase in income (column 6) in period t + 2 of 190 is arrived at by adding the

increase in income (column 5) of this period to the total increase in income 100 (of column 6) of

the previous period t+1.

Similarly, the total increase in income in period t+3 of 271 = increase in income of 81 in this

period plus 190 of column 6 of period t+2. This cumulative process of income propagation

continues till in period t + n, induced consumption, induced investment and increase in income

dwindle to zero.

If we add up the increase in consumption, investment and income from period t+1 to t+n, the

total income increases to Rs 1000 crores, total consumption to Rs 500 crores and total investment

to Rs 400 crores, given the initial investment of Rs 100 crores.

The dynamic path of income is shown in the adjoining Fig. 2. Income is measured vertically and

time horizontally. The curve OY1 shows the time path of income with a super-multiplier of 10.

The curve rises with time and reaches the new equilibrium level of income Y1 and flattens out. It

indicates that income increases at a decreasing rate.

3. Use of Multiplier-Accelerator Interaction in Business Cycles:

However, with different values of MPC and the accelerator, the multiplier-accelerator may show

different results in terms of cyclical fluctuations. Suppose the MPC is 0.5 and the accelerator

coefficient is 2. Given the same assumptions and the initial investment of Rs 100 crores, let us

study how changes in income take place. Table III explains this process of income propagation.
Table III reveals that in period t+1 there is an increase of Rs. 100 crores by the amount of initial

investment. This increase in income leads to a rise in consumption of Rs 50 crores (column 3) in

period t+2 because the value of MPC is 0.5.

This rise in consumption induces investment of Rs 100 crores = 50 x 2 (column 4), the

accelerator coefficient being 2. And income increases to Rs 250 crores (column 2+column

3+column 4). This increased income, in turn, leads to an increase in consumption of Rs 125

crores in t+ 3 period being one-half of Rs 250 crores as the MPC is 0.5.

But consumption in period t is a function of income of the previous period. Therefore, the actual

increase in consumption in period t+3 and t+2 i.e. 125-50=75. If we multiply this increase in

consumption 75 by the value of the accelerator 2, we get induced investment of 150=75×2

(column 4) in period t+3. Thus the total of columns 2+3+4 gives increase in income of Rs 375

crores in period t+3.

This increased income leads to induced consumption of 187.50 (column 3) in period t+4, since

MPC=0.5. The difference of induced consumption of period t+4 and t+3 (187.50 minus 125) is

62.50 which multiplied by the value of the accelerator 2 gives the figure of 125 of induced

investment (column 4).

And the total of columns 2, 3 and 4 gives the increase in income of Rs 412.50 crores (column 5)

in period t+4, and so on. The increase in income is the highest in period t+4 which shows the

peak of the cycle. Thereafter, it starts falling till it reaches the bottom or trough when income is

minus Rs 11.70 crores in period t+8.

Table III: Multiplier – Accelerator Interaction (Rs Crore)

Time(t) Initial Investment Induced Consumption(c=0.5) Induced Investment

(1) (2) (3) (4)

0 0 0 0

t+1 100 — —

t+2 100 50 100

t+3 100 125 150

t+4 100 187.50 125

t+5 100 206.25 37.50

t+6 100 171.88 -68.74

t+7 100 101.57 -140.62

t+8 100 30.48 -142.18

t+9 100 -5.48 -72.66

t+10 100 10.75 33.20

From period t+9, it again starts rising which shows the revival phase of the cycle. This behaviour

of income as a result of the combined operation of the multiplier and the accelerator reveals that

income first rises, then falls and again rises at constant amplitudes. The actual behaviour of the
cycle, however, depends on the values of the multiplier and the accelerator, as shown by

Samuelson in his model.

Kurihara points out that a less than unity marginal propensity to consume provides an answer to

the question. Why does the cumulative process come to a stop before a complete collapse or

before full employment? According to Hansen, this is due to the fact that a large part of the

increase in income in each period is not spent on consumption in each successive period.

This eventually leads to a decline in the volume of induced investment and when such a decline

exceeds the increase in induced consumption, a decline in income sets in. Thus, writes Hansen,

“It is the marginal propensity to save which calls a halt to the expansion process even when the

expansion is intensified by the process of acceleration on top of the multiplier process.”

THEORIES OF TRADE CYCLE / BUSINESS CYCLE

Economists have identified different causes for the occurrence of trade cycle in an economy and
formulated various theories of trade cycles. A systematic study of business cycles, however, is a
relatively recent development. Most of the important contributions to the theory of business
cycle were made in the first half of the twentieth century though business cycles has taken place
throughout the nineteenth century.

Theories of Business Cycle

The classical economists, Adam Smith, Mill, Malthus and Ricardo, have devoted little attention
to the causes of business cycles. The classical school believed that Say’s law, i.e.,

“Supply creates its own demand,”

was a valid representation of the world economic behavior and that unemployment appears only
if wages and interest rates are inflexible. Market forces, what Adam Smith called “invisible
hand” would by themselves maintain stability in the economy. Between 1890 and first World
War, however, a number of important contributions were made to the trade cycle theory.

Although many important contributions were made to the theory of business cycle prior to the
Great Depression, the study of business cycle still remained outside the general economic theory.
It was Keynes, who provided a general theoretical framework, in which the theory of business
cycle could be interwoven. In his General Theory he provided standard tools for analyzing the
economic fluctuations though he himself had said little about the cause of cyclical fluctuations.
Hicks has remarked that Keynesian economics had done all for understanding of business
fluctuations but has left out the analysis of business cycle itself. In the post-Keynesian era, the
main contributors to the cycle theory include Metzler, Harrod, Samuelson, Kaldor, Hicks,
Goodwin and Duesanberry.

The following theories are important contributions. For the sake of clarity, the theories can be
classified as

Non-monetary theories
These theories emphasis non-monetary causes. The non-monetary theories are:

1. Stanley Jevon’s sunspot theory.

2. Pigou’s psychological theory.
3. Socialist’s over production theory.
4. Douglas and Hobson’s over-saving theory/under consumption theory.
5. Schumpeter’s innovation theory.
6. Cobweb theorem.
Monetary theories
These asserts monetary causes. The monetary theories of trade cycle include,

1. Hawtrey’s theory of business cycle.

2. Hayek’s over investment theory.
3. Keyne’s theory of business cycle and
4. Hick’s’theory of business cycle.
In addition, there are good number of theories on business cycle propounded by economists.
Here, we can discuss. only a few important theories briefly.

Sun spot theory or climatic theory

This theory advocated by Jevons and Moore states that good climate and bad climate are
responsible for good and bad harvest and consequently economies enjoy periods of prosperity
and adversity. The climatic variations are supposed to be caused by the spots in the sun and
hence the name sun spot theory. Of course, this theory is not accepted in modern times, as the
trade cycles is not restricted to agricultural sector alone or to agricultural countries alone. Even
highly industrialized countries undergo the experience of trade cycles.

Psychological theory
This theory was propounded by Pigou, Beveridge and others, It is based on the psychological
feeling of optimism and pessimism in businessmen. This results in boom and depression in the
economy. The wave of optimism creates herd psychology and businessmen undertake business
activity enthusiastically. This theory is only partly true. Though psychological aspects give
momentum to an activity, the theory does not explain how the boom or slump is initiated. The
theory fails to explain as to how a depression starts and how a recovery begins.

Hawtrey’s theory or Monetary theory

According to Hawtrey, “Trade cycle is purely a monetary phenomenon” and he strongly
advocated that changes in the flow of money are exclusively responsible for the ranges in
economic activity which in turn create boom or depression.

The basic cause of boom or depression according to Hawtrey is the changes in the volume of
money which are brought about by the changes in the rate of interest. A reduction of rate of
interest by the banking institutions would enthuse the businessmen to borrow more and more and
expand business activity. If the rate of interest is increased, borrowings get reduced and as such
the business activities get reduced. In short, Hawtrey’s theory is nothing but inflation and
deflation created by the rate of interest.
This theory holds good only when the monetary system is under “Gold standard” where the
money supply would be rigidly fixed on the basis of gold stock. But in modern days, in the
absence of gold standard, the theory has become very weak. Further, borrowing and investments
will not depend upon the rate of interest and it could not be the cause of prosperity and
depression. If that be the case, controlling a boom and solving a depressionary trend would lend
an easy monetary solution of contracting and expanding money through the rate of interest. This
may be one of the causes and not the only cause influencing trade cycle.

Keyne’s theory of trade cycle

Keynes did not formulate a separate theory of trade cycle, but he has given it as a by-product of
his main theory of Income and employment propounded in the “General theory”.

According to Keynes, trade cycle may be regarded

as being occasioned by a cyclical change in the marginal efficiency of capital though

complicated and often aggravated by associated changes in the other significant short period
variables of the economic system.
Thus, the primary cause, of cyclical fluctuations is the marginal efficiency of capital (MEC) i.e.
changes in the rate of profit on current investment outlay and also due to changes in the rate of
interest. According to Keynes, MEC forms the vital factor in guiding investment decisions of
businessmen. But this factor depends on businessmen’s anticipation of future prospects, i.e. on
the psychology of inventors. In such a case, this theory approaches very near to psychological
theory.