The
algebraic equation for the determination of the equilibrium level of income
(and output) in our two-sector model (equation 6 26) yields an interesting
result and introduces us to the concept of the multiplier. The multiplier
concept is used to capture a process whereby a change (increase or decrease) in
any of the components of aggregate expenditure is amplified to that the overall
effect on the level of output, income and employment is greater than the
initial change.
algebraic equation for the determination of the equilibrium level of income
(and output) in our two-sector model (equation 6 26) yields an interesting
result and introduces us to the concept of the multiplier. The multiplier
concept is used to capture a process whereby a change (increase or decrease) in
any of the components of aggregate expenditure is amplified to that the overall
effect on the level of output, income and employment is greater than the
initial change.
An
injection into the income stream (for example, an increase in autonomous
investment) would lead to an amplified (a more than proportionate) increase in
income, output and employment. In other words, national income and output would
increase by a multiple of the increase in autonomous investment. This multiple
(the amount by which the increase in autonomous investment is multiplied to get
the increase in income and output) is called the multiplier. The multiplier is
valid for both an increase and decrease in investment and/or government
expenditure (in the case of a three-sector model). For a decrease in
investment, however, the multiplier would work in the opposite direction
leading to a multiplied reduction in national income, output and employment.
What then is the rational behind the multiplier?
injection into the income stream (for example, an increase in autonomous
investment) would lead to an amplified (a more than proportionate) increase in
income, output and employment. In other words, national income and output would
increase by a multiple of the increase in autonomous investment. This multiple
(the amount by which the increase in autonomous investment is multiplied to get
the increase in income and output) is called the multiplier. The multiplier is
valid for both an increase and decrease in investment and/or government
expenditure (in the case of a three-sector model). For a decrease in
investment, however, the multiplier would work in the opposite direction
leading to a multiplied reduction in national income, output and employment.
What then is the rational behind the multiplier?
We
explain by taking the case of an increase in planned business investment in the
two-sector model. An additional spending by the business sector will create
additional income for the household sector (since there will be increase in the
demand for factor inputs). This will increase the latter’s capacity to spend
(consume). Similarly, the increased expenditure of the household sector will
create additional income for the business spending which again creates
additional income for the household sector etc. This process will continue with
the initial increase in planned business expenditure generating circles of
increases in income will be a multiple of the initial increase planned business
investment.
explain by taking the case of an increase in planned business investment in the
two-sector model. An additional spending by the business sector will create
additional income for the household sector (since there will be increase in the
demand for factor inputs). This will increase the latter’s capacity to spend
(consume). Similarly, the increased expenditure of the household sector will
create additional income for the business spending which again creates
additional income for the household sector etc. This process will continue with
the initial increase in planned business expenditure generating circles of
increases in income will be a multiple of the initial increase planned business
investment.
If
we assume, for example, that planned autonomous investment expenditure
increased byN500m (from N400m assumed earlier to N900M). if the propensity (tendency) of
households is to spend eighty percent of every additional income (i.e. the MPC
is 0.8), we can analyse the effect of the increase in investment on the equilibrium
level of income, output and employment by means of table 6-1. In the table, the
increase (change) in planned business investment (N500m) constitutes the whole increase in income in the first
circle. When this increase gets into the economy (as households’ services are
employed by the business sector and money is paid them in form of factor
incomes), households spendN400m) (0.8
x 500m) out of it and save the remaining hundred million the saving leaks out
of the income stream, (i.e., does not enter into the next circle) so that the
change (increase) in income in the next circle isN400m. Again this increase the income and leads to additional
spending by households of (0.8 x 400m)N320m
and savings ofN80m.
we assume, for example, that planned autonomous investment expenditure
increased by
households is to spend eighty percent of every additional income (i.e. the MPC
is 0.8), we can analyse the effect of the increase in investment on the equilibrium
level of income, output and employment by means of table 6-1. In the table, the
increase (change) in planned business investment (
circle. When this increase gets into the economy (as households’ services are
employed by the business sector and money is paid them in form of factor
incomes), households spend
x 500m) out of it and save the remaining hundred million the saving leaks out
of the income stream, (i.e., does not enter into the next circle) so that the
change (increase) in income in the next circle is
spending by households of (0.8 x 400m)
and savings of
The
process of income in income leading to increased consumption and back to
increased income etc. continues until the circle is exhausted. From the above
analysis, it is clear that the ultimate size of the change in national income,
output, and employment will be dependent on the marginal propensity to consume
(what fraction of an additional unit of income received by households is
spent). The size of the MPC will determine the number of circles by means of
which changes in consumption is transmitted to changes in national income and
also the size of the changes in consumption expenditure in each circle. In
particular,
process of income in income leading to increased consumption and back to
increased income etc. continues until the circle is exhausted. From the above
analysis, it is clear that the ultimate size of the change in national income,
output, and employment will be dependent on the marginal propensity to consume
(what fraction of an additional unit of income received by households is
spent). The size of the MPC will determine the number of circles by means of
which changes in consumption is transmitted to changes in national income and
also the size of the changes in consumption expenditure in each circle. In
particular,
1.
The higher the MPC, the higher the
greater the change in consumption expenditures that will be associated with a
change in income, the larger the absolute size of the multiplier and the larger
the total change in income that will be generated by the initial change in
autonomous investment spending.Conversely,
The higher the MPC, the higher the
greater the change in consumption expenditures that will be associated with a
change in income, the larger the absolute size of the multiplier and the larger
the total change in income that will be generated by the initial change in
autonomous investment spending.Conversely,
2.
The higher the MPS, the lower the
change in consumption that will be generated by changes in income, the smaller
the absolute value of the multiplier and the smaller the total change in income
that will be associated with the initial change in investment.
The higher the MPS, the lower the
change in consumption that will be generated by changes in income, the smaller
the absolute value of the multiplier and the smaller the total change in income
that will be associated with the initial change in investment.
Numerically,
the multiplier is
the multiplier is
K
=
= 
6.30
=
= 6.30
This
simple Keynesian multiplier (6.30) shows by how musch a change in planned
autonomous spending will be multiplied to derive the change income and output.
The lower the denominator (1 –MPC = MPS), the higher the absolute value of k.
in our example, since MPC = 0.8, k = 1/1-8 = 1/0.2 =. For a smaller –sized MPC,
e.g. 0.6, the multiplier (k) will be 1/1-0.6 = 1/0.4 = 2.5. An alternative way
we can derive the value of the multiplier is to find the ration of the total
change in income to the original in autonomous spending. Using our previous
illustration, this will give;
simple Keynesian multiplier (6.30) shows by how musch a change in planned
autonomous spending will be multiplied to derive the change income and output.
The lower the denominator (1 –MPC = MPS), the higher the absolute value of k.
in our example, since MPC = 0.8, k = 1/1-8 = 1/0.2 =. For a smaller –sized MPC,
e.g. 0.6, the multiplier (k) will be 1/1-0.6 = 1/0.4 = 2.5. An alternative way
we can derive the value of the multiplier is to find the ration of the total
change in income to the original in autonomous spending. Using our previous
illustration, this will give;
K
= Y/I 6.31
= Y/I 6.31
Which
can be rewritten as 6.32?
can be rewritten as 6.32?
Spending
to the desire level. A macroeconomic policy intended to increase the level of
planned aggregate spending (shift the aggregate demand curve rightward is
called an expansionary policy. On the other hand, if aggregate demand exceeds
the level required to maintain the economy at the full employment level, there
will be an inflationary gap in the economy. An inflationary gap implies that
what people planned to spend is above the amount needed to buy off the goods
and services the economy can produce when available resources are fully
employed. There is excessive demand for
goods and services creating upward pressures on prices. Again macroeconomic
policies may be used to reduce planned aggregate expenditure and close up an
inflationary gap. Such policies directed at reducing planned aggregate spending
(shifting the aggregate expenditure curve leftward) are called contractionary
policies.In the simple two-sector model, planned aggregate expenditures can be
increased (decreased) by increases (decrease) by increases (decreases) in
planned business investment.
to the desire level. A macroeconomic policy intended to increase the level of
planned aggregate spending (shift the aggregate demand curve rightward is
called an expansionary policy. On the other hand, if aggregate demand exceeds
the level required to maintain the economy at the full employment level, there
will be an inflationary gap in the economy. An inflationary gap implies that
what people planned to spend is above the amount needed to buy off the goods
and services the economy can produce when available resources are fully
employed. There is excessive demand for
goods and services creating upward pressures on prices. Again macroeconomic
policies may be used to reduce planned aggregate expenditure and close up an
inflationary gap. Such policies directed at reducing planned aggregate spending
(shifting the aggregate expenditure curve leftward) are called contractionary
policies.In the simple two-sector model, planned aggregate expenditures can be
increased (decreased) by increases (decrease) by increases (decreases) in
planned business investment.
Thus,
in the model, expansionary and concretionary policies are directed at
influencing business investment’s decision. However, it is the size of the
multiplier (6.30) that will determine by how much planned business investment
will have to increase (decrease) in order to achieve a given increase
(decrease) in planned aggregate spending. For example, if equilibrium is at
point e, in Fig 6-7 (panel 1) and the equilibrium income isN4500m, since the full employment equilibrium
income (output) isN8000m, output
(income) will need to rise byN3500m(N8000m – N4500)
in order to close up the deflationary gap. But planned aggregate spending (or
more specifically, planned business investment) need not rise by that amount in
order to achieve such an increase in equilibrium income. If we assume
households’ marginal propensity to consume (MPC) remains at 0.80., then the
numerical value of the multiplier is 5 and the change in planned business
investment required to achieved the given change in income is
in the model, expansionary and concretionary policies are directed at
influencing business investment’s decision. However, it is the size of the
multiplier (6.30) that will determine by how much planned business investment
will have to increase (decrease) in order to achieve a given increase
(decrease) in planned aggregate spending. For example, if equilibrium is at
point e, in Fig 6-7 (panel 1) and the equilibrium income is
income (output) is
(income) will need to rise by
in order to close up the deflationary gap. But planned aggregate spending (or
more specifically, planned business investment) need not rise by that amount in
order to achieve such an increase in equilibrium income. If we assume
households’ marginal propensity to consume (MPC) remains at 0.80., then the
numerical value of the multiplier is 5 and the change in planned business
investment required to achieved the given change in income is
I
= Y/K
= Y/K
Where
I = change in planned business investment and
I = change in planned business investment and
Y
= change in equilibrium income and output.
= change in equilibrium income and output.
Thus
for an increase ofN3500m in
output/income, planned business investment must rise byN700m (N3500m/5). In other words it would require an initial
increase in planned business investment of onlyN700m to close up the deflationary gap of N3500m. This is because the increase in investment will have
multiplier effect on equilibrium income and output. Symbolically, Y ≥ I as it
is evident in Fig. 6-4. In fact,
for an increase of
output/income, planned business investment must rise by
increase in planned business investment of only
multiplier effect on equilibrium income and output. Symbolically, Y ≥ I as it
is evident in Fig. 6-4. In fact,
Y
= I – K
= I – K
The
same analysis applies in the case of an inflationary gap. The size of the
multiplier will determine by how much planned business investment expenditure
will have to fall in order to reduce aggregate expenditure to the desired
level,the greater the MPC, the greater the size of the multiplier and the lower
the reduction in investment that will be required to close up the inflationary
gap.
same analysis applies in the case of an inflationary gap. The size of the
multiplier will determine by how much planned business investment expenditure
will have to fall in order to reduce aggregate expenditure to the desired
level,the greater the MPC, the greater the size of the multiplier and the lower
the reduction in investment that will be required to close up the inflationary
gap.
