With countries always looking to increase employment and investment, F.A. Kahn came up with the concept of the Multiplier, which was later refined by J. M. Keynes. Known today as the Keynesian Multiplier, it asserts how an increase in private consumption expenditure, investment expenditure or the net government spending can affect and raise the Gross Domestic Product (GDP).
Keynes brought forward this idea in his book ‘The General Theory’ published in 1930 wherein he attempted to explain short-term economic fluctuations. The main idea was that recessions and depressions can occur due to there being a lack of demand for the goods and services in the economy. The General Theory was a helping guide not only for economists but also policymakers. At the time of the book being published, Keynes called for there to be an increase in government spending causing a surge in demand for the goods and services available in the market. This thinking went against all classical thoughts as it sought government intervention.
Keynesian economics comprises of three elements:
- Aggregate Demand, which is influenced by the private and public sector. The private sector has great pull and influence upon the macroeconomic conditions and even the smallest changes can have drastic impacts.
- Prices and Wages do not react instantaneously to the change in demand and supply in the economy, which results in shortage or excess of labour.
- Changes in aggregate demand deeply impact the output and employment equilibrium of the economy. The theory suggests that increasing the spending in one sector, will lead to an increase of spending in all sectors.
The multiplier suggests that the level of change in the output and employment is a multiple to the increase/decrease in the spending done by the Government.
There are a few key terms to be understood to figure out how to calculate and understand the workings of the multiplier.
- Marginal Propensity to Save (MPS) – This measure the change in total savings, due to the change in income. When there is an increase in the income of the individual, the proportion that is saved is measured. The formula for it is MPS = ΔSavings/ΔIncome. Suppose an individual receives $1000 and spends $500, his MPS would be 0.5 as (1000-500)/500, which is the formula.
- Marginal Propensity to Consume (MPC) – This measure the change in total consumption, due to a change in the income. This measures how the consumption
- pattern of the individual changes after an increase in their income. The formula for it is MPC = ΔConsumption/ΔIncome. The Keynesian theory states that when there is an increase in the production, there is an increase in income, therefore an increase in spending. The value of the multiplier is also calculated from the MPC. The formula for which is M = 1/(1-MPC).
The multiplier is completely a theoretical concept which cannot be applied in the modern world due to all the assumptions that are taken to make it function.
This is a hypothetical example of the working of the multiplier, where assuming MPC = 0.5, and the initial investment in $100
Total Increase is the value of the multiplier effect, therefore:
Multiplier = 1/(1-MPC) => 1/0.5 => 2
Hence, the initial investment will be doubled which is $200.
How it works
Understanding how the multiplier works is quite simple – the government invests the $100 into the economy, which becomes an individual’s income. Assuming that the MPC is 0.5, the individual will spend half of the $100 and spend the other half. The $50, that he spends become another individual’s income, who then spends half of this and saves the other half. This cycle is repeated until the initial investment reaches an insignificant value or zero. This cycle causes economic growth, and generates more than a dollar in economic growth. In theory, the lesser the population spent, the higher the growth rate for the economy and if they avoided savings altogether the economy would be running at full employment. Keynes even suggested taxing savings so that individuals would spend more money. This model also shows that, unless someone actually hoards the money on their person, it will be invested in the economy, either by them or the banks.
The multiplier has two limitations, one is when the marginal propensity to consume is equal to 1, which is when there is no saving. This means, that even a marginal increase in spending will bring forward a large change in income and employment. However, such a case is unlikely as the marginal propensity to consume is always less than 1 in the real world.
The other limiting case is when the marginal propensity to consume is equal to zero. When this situation arises, there is no change in the initial investment value as the value of the multiplier is 1.
Plenty assumptions are made to ensure that the multiplier can function in an economy. The first of which would be the marginal propensity to consume. Assuming that the MPC will remain constant even as income increases is not possible in the real world, nor is each and every individual spending the same percentage of their income.
The second assumption is that there are no external forces acting upon the initial investment, nor is there an increase in this investment at any point in time. If they do occur, they need to be included in the calculations.
Third assumption would be the elimination of time lag, and the immediate spending of the income received by the individual. In essence it means that there is instantaneous change in income, due to the change in investment.
The last assumption made is that there is excess of supply for the goods and services being provided, to match the increase in demand which will be present due to the additional investment and increase in purchasing power of the individual. If there is no excess supply, there will be inflation rather than increase in real income, output and employment.
The multiplier is a well-known concept to model the process of expenditure and savings, from an initial investment causing for economic growth. The concept was suggested to boost productivity in the times of depression and recession. The model was never tested out in the real world due to there being only two components visible in theory, whereas in reality, for the multiplier to function there would need to be a breakdown of all the large variables involved and excluded in the theoretical approach – which play an important role in the real world.
The multiplier will always remain a theoretical concepts due to the limitations caused by the assumptions made, as history and behavioural economics show that on a macroeconomic scale there will never be the same percentage of spending done by individuals; especially when there is an increase in income – as higher income results in higher purchasing power.
Research and opinions show that many economists agree and buy into the idea of the multiplier. But no matter the returns it does promise, the concept does not make sense in reality. The concept cannot be supported on logical grounds due to the assumptions that are made to understand the concept in a theoretical format.