Theory of Multiplier 2

8/4/2019 Theory of Multiplier 2

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Keynesian Theory of IKeynesian Theory of Iincome determination &income determination &

Theory of MultiplierTheory of Multiplier

UnitUnit -- 22


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Income DeterminationIncome Determination

Keynesian Model is for short runKeynesian Model is for short run

Short run prices fixed

output determined by aggregate demand

unemployment is negatively related to output


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Differences between theDifferences between the

Classical and KeynesClassical and Keynes

Labour supply depends onLabour supply depends on

the real wage rate.the real wage rate.

There is no money illusion.There is no money illusion.

The economy is at fullThe economy is at fullemployment equilibriumemployment equilibrium

Market EconomyMarket Economy

Supply of labour dependsSupply of labour depends

on the money wage rate.on the money wage rate.

There is money illusion.There is money illusion.

The economy is atThe economy is atunderemploymentunderemployment

equilibriumequilibrium..

Mixed EconomyMixed Economy


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Concept of ADConcept of AD

Aggregate demand is measured in terms ofexpenditure.Aggregate demand is measured in terms ofexpenditure.

Aggregate demand means aggregateexpenditure on theAggregate demand means aggregateexpenditure on thepurchase of domestically produced goods & services during anpurchase of domestically produced goods & services during anaccounting year.accounting year.

Thisexpenditure is to beestimated as desired expenditure orThisexpenditure is to beestimated as desired expenditure orplanned expenditure.planned expenditure.


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AD scheduleAD schedule

InIn orderorder toto simplifysimplify wewe initiallyinitially assumeassume wewe havehave closedclosedeconomyeconomy withwith nono governmentgovernment ,, soso desireddesired expenditureexpenditure ofof thethepeoplepeople consistsconsists ofof onlyonly twotwo componentscomponents CC && II..

ADAD == C+C+ II


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Concept of ASConcept of AS

AS refers flow of good & services as planned by the producersAS refers flow of good & services as planned by the producersduring an accounting year.during an accounting year.

It implies flow of goods & services in theeconomy during anIt implies flow of goods & services in theeconomy during anaccounting year.accounting year.

Since Y = C+SSince Y = C+S

AS = C+SAS = C+S


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AS

Y

O X

AS line happens to be a 45 line .

This is because of the obviousidentify between Y on the X-axis& C + S

OUTPUT

Factors ofproduction


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Marginal Propensity ToMarginal Propensity To

ConsumeConsume Marginal propensity to consume is the ratio of change inMarginal propensity to consume is the ratio of change in

consumption to a change in income.consumption to a change in income.

MPC = change in consumption/ change in incomeMPC = change in consumption/ change in income

Consumption function is written asConsumption function is written as

C = C + bY ( b is the marginal propensity to consume)C = C + bY ( b is the marginal propensity to consume)


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Income ( Y)Income ( Y)

( RsCrore)( RsCrore)

Change inChange inincomeincome

(Y)(Y)

ConsumptionConsumption

( RsCrore)( RsCrore)

Change inChange inconsumptionconsumption

MPCMPC

100100 -- 8080 --

200200 100100 120120 4040 40/100 = 0.440/100 = 0.4

300300 100100 150150 3030 30/100 = 0.330/100 = 0.3

Marginal Propensity to Consume


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Concept of equilibriumConcept of equilibrium

level of Income & outputlevel of Income & output

Expenditure

y

o x

Y

AD = C + IQ

LINCOME OUTPUT

Q is the point of equilibriumwhere AD = AS

E>Y

E


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Y = C+ SY = C+I I : AutonomousInvestment

C : Autonomous consumption

Y = C+I

= C+bY+I

Y bY = C+I

Y = C+I (where b is marginal propensity to consume)

1 b


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Concept of multiplierConcept of multiplier

MultiplierMultiplier refersrefers toto thethe factorfactor byby whichwhich outputoutput // incomeincomeincreasesincreases ,, becausebecause ofof increaseincrease inin investmentinvestment.. ItIt isis measuredmeasuredasas ratioratio of of increaseincrease inin incomeincome // outputoutput && increaseincrease inin

investmentinvestment..

KK == ChangeChange inin incomeincome // changechange inin investmentinvestment


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K = Y / I

Y = C+ I

Y = C + I

I = Y - C

Putting value of I in equation 1

K = Y / Y - C

Dividing right hand side of equation by y

K = 1 / 1- MPC

Derivation of multiplier


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Assumptions of MultiplierAssumptions of Multiplier

There is change in autonomous investment & inducedThere is change in autonomous investment & inducedinvestment is absent.investment is absent.

The MPC is constantThe MPC is constant

Consumption is a function of current income only.Consumption is a function of current income only.

There are no changes in pricesThere are no changes in prices

There is closed economy.There is closed economy.

There are no time gaps between multiplier process..There are no time gaps between multiplier process..


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Implications of MultiplierImplications of Multiplier

AA higherhigher MPCMPC raisesraises thethe valuevalue ofof thethe multipliermultiplier..

TheThe multipliermultiplier worksworks bothboth thethe sidessides (( riserise inin incomeincome && fallfall ininincome)income)

MultiplierMultiplier workingworking isis dependentdependent uponupon anan assumptionassumption ofofunderutilizedunderutilized resourcesresources..

MultiplierMultiplier willwill workwork if if anyany autonomousautonomous componentcomponent of of ADADchangeschanges..


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Leakages in MultiplierLeakages in Multiplier

SavingsSavings

Strong liquidity preferenceStrong liquidity preference

Purchase of old stocks & securitiesPurchase of old stocks & securities

Debt cancellationDebt cancellation

Net importsNet imports

Undistributed profitsUndistributed profits

TaxationTaxation


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Dynamic MultiplierDynamic Multiplier

AA dynamicdynamic modelmodel ofof multipliermultiplier cancan bebe formulatedformulated byby usingusingperiodperiod oror sequencesequence analysisanalysis whichwhich considersconsiders timetime pathpath ofofchangeschanges inin relevantrelevant variablesvariables andand alsoalso inin whichwhich valuevalue ofof oneone

variablevariable inin periodperiod dependsdepends onon itsits valuevalue inin previousprevious periodperiod..

InIn casecase ofof dynamicdynamic multipliermultiplier wewe areare consideringconsidering aatimetime laglag inin consumptionconsumption functionfunction..

YYTT == CCTT++ IITT

CCTT == aa ++ bYbYTT-- 11YYTT == aa ++ bYbYTT-- 11 ++ IITT

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Theory of Multiplier 2