MacroeconomicsMultiplier Theory in the SKM

Dipankar DeMumbai, October 2007

Narsee Monjee Institute of Management Studies(Deemed University)

Multiplier in Simple Keynesian Model

1. What do you mean by Multiplier?

2. How does it work in the system?

3. Why focus multiplier?

• The term ‘multiplier’ is used in economics to mean the effect

on some endogenous variable (a variable whose level is

explained by the theory being studied) of a unit change in an

exogenous variable (a variable whose level is not determined

within the theory under study

Topics to be covered…

Multiplier in Simple Keynesian Model

• The effect of a change in autonomous investment on

equilibrium income is captured by the ‘investment multiplier’

• It is the rate of change of the equilibrium income w.r.t the

autonomous investment expenditure.

• The value of the investment multiplier in the SKM is greater

than one.

• The expression is :

• It shows the magnitude of change in equilibrium income, if

there is one unit change in autonomous investment.

• Since 0<mpc<1, the investment multiplier is greater than

unity.

mpsmpcdI

dY 1

1

1

Multiplier in Simple Keynesian Model

• Implication of the multiplier theory is that an increase in the

autonomous investment or any expenditure produces an

expansionary effect on income. The expansion of income will

be much greater than the original increase in expenditure.

• In the first round, the increase in investment expenditure

produces a rise in the AD just by the amount of the increment

in the investment only.

• Then the resultant increase in income leads to an increase in

the consumption expenditure. This increase in the C

expenditure leads to a further increase in the AD, which

produces a further increase in income.

Multiplier in Simple Keynesian Model

• In this way, the process continues, until the effect is

exhausted.

• So it is the successive increments in the consumption

expenditure which produce the multiplier effect on income

• The process approaches a limit in course of time, since the

successive increments become smaller & smaller in a

geometrical progression.

dImpcmpcmpcdy

dImpcmpcdympcdIdy

dImpcdympcdIdy

dIdy

nn

)......1(

)1(

)1(

12

223

12

1

Multiplier in Simple Keynesian Model

• The multiplier process works in this way: expenditure made in

production is paid to the people as factor income; income is

spent by the people to purchase goods for consumption; the

consumption expenditure creates a demand for goods; and

then the increase in production, creating new income, takes

place

• A complete round of income creation may have the following

3 lags:

1. Payment lag

2. Consumption lag

3. Production lag

• The lags have the effect of delaying the realization of the

multiplier result

Why focus multiplier?

We are developing an explanation of fluctuations in output

The multiplier suggests that output changes when autonomous spending (including investment) changes & that the change in output can be larger than the change in original expenditure

If the economy for some reason - say a loss in confidence that reduces investment spending – experiences shock that reduces income, people whose income have gone down will spend less, thereby driving the equilibrium income down even further.

Thus multiplier is potentially a part of the explanation why output fluctuates