Macroeconomics_lecture 4 Skm Multiplier

Narsee Monjee Institute of Management Studies (Deemed University)

Macroeconomics Multiplier Theory in the SKM

Dipankar De Mumbai, October 2007

Multiplier in Simple Keynesian Model Topics to be covered… 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

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.

dY 1 1 = = 1 −mpc mps • The expression is : dI

• It shows the magnitude of change in equilibrium income, if there is one unit change in autonomous investment.

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

dy1= dI

geometrical progression.

dy2 = dI + mpc ∗ dy1 = (1 + mpc) ∗ dI dy3 = dI + mpc ∗ dy2 = (1 + mpc + mpc 2 ) ∗ dI dyn = (1 + mpc + mpc 2 + ...... + mpc n −1 ) ∗ dI

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

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