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Unit 7: Concept of Multiplier

Using the definitions of marginal propensity to save, and of marginal propensity to import, m, Notes
we can say S = & Y
M = m Y
Equation (4) can now be
(&+m) = J + X ...(5)
Hence, we get
1
Y = ( J+ X) ...(6)
s+m
The changes in investment and exports can now be viewed as autonomous variables and the
effects of change in, say, exports on the national income can be studied.
Equation (6) shows that the effect of change in exports on the national income equals the change
in exports multiplied by the expression 1/s+m, which is the foreign trade multiplier or k .
f
k works like the simple inverse multiplier. An increase in exports gives rise to an increase in
f
income for exporters and those employed in export industries. They, in turn, spend more of
their increased incomes. How much more they spend on domestic goods depends on two leakages:
how much they saved and how much they spend on imports. The savings do not create any new
incomes. An increase in import spendings does not create new incomes in the country itself,
only in those foreign countries with which the first country trades.
It is now easy to see that the larger the marginal propensities to save and import, the smaller
will be the value of the multiplier.

Example: If the marginal propensity to save is 0.2 and if the marginal propensity to
import is 0.3, the value of k = 1/(0.2+0.3) = 2; i.e., an autonomous increase in exports of 100 will
f
lead to an increase in national income of 200.

Case Study Much do about Multipliers

t is the biggest peacetime fiscal expansion in history. Across the globe countries have
countered the recession by cutting taxes and by boosting government spending. The
IG20 group of economies, whose leaders meet this week in Pittsburgh, have introduced
stimulus packages worth an average of 2% of GDP this year and 1.6% of GDP in 2010.
Coordinated action on this scale might suggest a consensus about the effects of fiscal
stimulus. But economists are in fact deeply divided about how well, or indeed whether,
such stimulus works.
The debate hinges on the scale of the “fiscal multiplier”. This measure, first formalised in
1931 by Richard Kahn, a student of John Maynard Keynes, captures how effectively tax
cuts or increases in government spending stimulate output. A multiplier of one means
that a $1 billion increase in government spending will increase a country’s GDP by
$1 billion.
The size of the multiplier is bound to vary according to economic conditions. For an
economy operating at full capacity, the fiscal multiplier should be zero. Since there are no
spare resources, any increase in government demand would just replace spending

Contd...

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