Principles of Economics Chapter 8

PRC-03

Sajjad Ahmad Malik

FACULTY MEMBER: RISE PREMIER SCHOOL OF ACCOUNTANCY
 MULTIPLIER PRINCIPLE:

Concept of multiplier moves around the basic phenomenon. That is “Spending of one is income to the
other”.
Investment Multiplier: (simple/closed economic model)
Investment multiplier is the ratio of the change in total output due to the change in investment.
Keynes definition: “Smaller change in investment causes greater change in output.”

Multiplier = ∆𝑌, K = ∆𝑌, or ΔY =k(ΔI)

∆𝐼 ∆𝐼

Value of multiplier (k) lies between: (1 < K < 𝖺)

For example:
Output increases by Rs. 2000 billion as result of change in investment by Rs. 500 billion, then themultiplier
will be 4

Multiplier formula:
Multiplier = 1/ (MPS + MPT + MPM)

Positive Multiplier and Negative Multiplier: (Multiplier works in both directions).

• Positive Multiplier refers to a greater increase in final output due to a small increase in
investment.
• Whereas Negative Multiplier refers to greater fall in final output from a tiny decrease in
investment

Working of the Multiplier:

Assume that MPC is 0.8, which means MPS is 0.2. Further, assume that Rs. 1,000 is introduced in the
economy.
If there is an increase in investment in an economy by Rs.1000, and the overall effect on the total
output of the economy was Rs.5000, then the multiplier effect would be equal to 5.

Round Initial Change in Income Change in Change in Saving

Investment (∆I) (∆Y) Consumption (∆C) (∆S)
1 1000 1000 800 200
2 800 640 160
3 640 512 128
- 2560 2048 512
Total 1000 5000 4000 1000
 S&I

S
I2
Δ I = 1000
I1
ΔY=5000

Y1 Y2 Output (Y)

In the graph above, MPC is assumed to be 0.8 and initial change in investment of Rs. 1,000.
Theinvestment of Rs. 1,000 will lead to an in GNP by Rs.5,000.

Therefore, each Rs.1 of investment has been “multiplied” 5 times.

Assumptions of Multiplier:
1. Constant marginal propensity to consume:
In multiplier model, it is assumed that there is no change in marginal propensity to
consume. Any change in MPC, can affect total change in the final output.
2. Continuous spending:
For the creation of the state of multiplier, the investment has to be continuous.
3. No change in price level:
Despite the change in income, there should be no change in prices of goods. Any change in
good’s
prices can change consumption pattern.
4. Full employment has not achieved:
If there is no spare capacity in the economy or economy is operating at full
employment, an increase in the government investment may lead to inflation, which
would lessen the ‘real’ effectsof the investment

5. No change in Tax rate:

Any change in tax rate causes to change in disposable income which further affects the
consumption pattern. Hence for smooth process of multiplier, a stable fiscal policy is
needed

1.1: MULTIPLIER EXTENSION:

1. Tax Multiplier (Kt) (Multiplier in closed economic model in presence of government)

• Marginal propensity to tax (MPT);
the percentage of income that is paid to the government in the form of tax
1
Kt =
𝑀𝑃𝑆+𝑀𝑃𝑇
Suppose the people are saving 30% of their income voluntarily and paying 20%
as tax to thegovernment then the tax multiplier will be: (Ans = 𝐾𝑡 = 2)

2. Import Multiplier Km (Multiplier in An Open Economic Model)

• Marginal Propensity to Import (MPM)
is the percentage of income that is used to buy goods and services outside of the
domesticeconomy.
1
Km =
𝑀𝑃𝑆+𝑀𝑃𝑇+𝑀𝑃𝑀

Suppose people are saving 30% of their income voluntarily and paying 20% as tax to the
government.In addition, people are also spending 10% of their income on imports, then
the value of multiplier will be: (Ans = 𝐾m = 1.67)

Note:
MPS, MPT and MPM are the Withdrawals /Leakages
There is an inverse relationship between leakages and Multiplier

Multiplier effect: limitations:

1. Full employment level:
If economy is at full employment level, then multiplier will be ineffective and further
increase ininvestment will cause increase in prices and NOT much increase in GDP.
2. Leakages:
Leakages from the circular flow of income would make the value of multiplier very low and
extraspending in the economy would have nominal effect in GDP
3. Availability of consumer goods: Operation of multiplier works only if consumer
goods are available in surplus. If sufficient amount of consumer goods is not available,
consumers will not be able to spend their income along any increase in their income.
4. Time lag:
There is a time lag exists between when the initial investment will be made, and
when the full effects of the multiplier will be felt.

PART-02: ACCELERATOR PRINCIPLE (β):

According to “J.M. Clark” demand for capital goods increases as result of increase in demand
forconsumer goods, which ultimately induces firms to make more investment.

Definition: Accelerator principle (β):

Smaller change in output causes greater change in investment. If output increases, then
firms will have to invest more in order to maintain a higher output.

I = 𝑓 (Y),
whereas
ΔI = β (𝛥Y) or β = ΔI
ΔY
Assumptions of Accelerator Principle:
1. Capital-Output ratio remains same.

2. Existing plants are operating at full capacity:

Installation of new plants would be necessary in order to meet any change in demand
for consumer goods. As for available reserve capacity, production at plants can be
increased without making new investments.
3. Availability of resources:
There is surplus availability of resources to provide more plants and equipment
needed to produce consumer goods. If it is not so, then the demand for new plants to
produce consumer goods will not be viable.

4. Flexibility in production:
Existence of high degree of flexibility in production process for smooth functioning of this
model.

5. Credit money is considered to be elastic: Credit is considered to be elastic, such

that funds forinduced investment are readily available.

Explanation of Acceleration Principle:

Year Y RequiredStock Net investment Depreciationor Gross investment
(Output) of capital [2] replacement cost [4]
[1] [3]
T 100 200 - - -
T+1 100 200 0 10 10
T+2 120 240 40 10 50
T+3 140 280 40 12 52
T+4 160 320 40 14 54
T+5 160 320 0 16 16
Explanation:
In this example,
[1] : Capital: output ratio = 2:1
[2] : Net investment = 2*change in output compared to
previous year[3]: Depreciation = 5%*Stock of previous
year’s capital
[4]: Gross investment = Net investment + depreciation
(replacement cost)Every year one plant has to be replaced

• This shows how when output is increasing, the level of gross investment jumps up
dramatically.
• On the flipside, if output begins to drop, then we see a sharp decrease in the level of
investment.
• This is why it is called the accelerator effect: a change in output accelerates the
change in theinvestment.

Limitations of Accelerator Effect:

 Existence of Spare Capacity:
There may be spare capacity within the firm which means it does not need to increase net
investmentby such a large amount – its existing resources could manage.

Adjustment /Time Lag cost:

Time and cost required to adjust level of capital stock are not considered in this simple
model. Thesecosts may be business costs due to installation of new machinery.

Full Employment is not yet reached:

Accelerator principle works only if full employment level in an economy has not yet
reached. If oncefull employment has reached, then resources like labour and capital will no
longer available to produce consumer goods. Therefore, accelerator principle will become
ineffective.

Constant Capital-Output ratio is impracticable:

Accelerator principle is workable only if there is a constant C.O.R., which is not possible
practically.

Sustainable increase in demand for consumer goods:

Accelerator principle works only if there is a long-term increase in demand for consumer goods.

2.1: MULTIPLIER, ACCELERATOR INTERACTION AND NATIONAL INCOME

According to Samuelson, cyclical fluctuation in economic activity over the time is due to
interaction between the multiplier and accelerator.

Suppose that output (Economy) is growing

• This induces investment (Io) via the accelerator principle.
• The new investment gives further rise to output through the multiplier effect.
• This means that the rate of growth of output will be self-sustaining. However,
the rate ofgrowth will eventually meet a point where GNP can no longer keep up.
• If this is the case, the level of (desired) output will soon exceed the production
capability of the economy.
Consequently, the rate of investment in the economy will have to decrease, as firms
would nolonger want to commit resources, when there will not be demand to
meet it.

Output (Economy) is slow down

• When output slows, there is a sharp decline in investment due to negative accelerator.
• Decrease in investment leads to sharp decrease in output, due to the reverse
effect of themultiplier.
• This effect will then be accelerated again, causing output in the economy to drop
significantly.

To explain how multiplier-accelerator interaction causes to economic fluctuations, we use

followingtable and given information:
Co = 10, MPC = 0.5
Induced Investment = ΔC (2)
 Multiplier, Accelerator Interaction
Total Change in
Induced Y
Years Co cY = 0.5Y Economic situation
Investment(ΔCx2)
(C+I)
0 10 0 0 10
Increasing Output
1 10 5 10 25
(Economic Growth)
2 10 12.5 15 37.5
3 10 18.8 12.6 41.4 Peak/Boom
4 10 20.7 3.8 34.5
Decreasing Output
5 10 17.2 -3.5 23.8
(Economic Downturn)
6 10 11.8 -10.6 11.1
Lowest Output
7 10 5.5 -12.6 2.9
(Depression)
8 10 1.4 -8 3.3
Increasing Output
9 10 1.6 0.4 12
The above table shows cyclical fluctuations in the economy, also called business cycle.

Part-03: BUSINESS CYCLE

Business Cycles:
Business cycle describes the recurring fluctuations of output that an economy
experiences over a long period of time. The patterns of output fluctuations are known as
business cycles.

3.1: PHASES AND CHARACTERISTIC OF BUSINESS CYCLE:

1. Peak/ Boom:
Peak is the phase of business cycle where economic activities is at highest level
and cannotexpand further.
 HIGH
Aggregate Economic Business Investment Employment
demand growth/Output confidence
Bank Credit Rate of interest Inflation General Price Level and Profits ofbusinesses

2. Recession/ Downturn:
At this stage, economic activity begins to slow down just after the peak. Deflation is a
recessionary indicator because price goes down.
DECREASING
Aggregate Economic Business Investment Employment
demand growth/Output confidence
Bank Credit Rate of interest Inflation General Price Level and Profits ofbusinesses

3. Depression/ Trough:
Long recession is called Depression. At this stage economic activity is at its lowest, meaning
the business cycle is at its trough.
LOW
Aggregate Economic Business Investment Employment
demand growth/Output confidence
Bank Credit Rate of interest Inflation General Price Level and Profits ofbusinesses

4. Recovery/Revival:
From the low point, there is an increase in levels of economic activity as aggregate
demand beginsto increase slightly.
The depression does not last forever. Economy gradually converts itself into revival and the
cyclecontinues.
INCREASING
Aggregate Economic Business Investment Employment
demand growth/Output confidence
Bank Credit Rate of interest Inflation General Price Level and Profits ofbusinesses

Part-01: ECONOMIC GROWTH

Economic Growth:
• According to Friedman, “economic growth is an expansion of system in one or
moredimensions without a change in its structure.”
• Economic growth in macroeconomics means long term increase in economic activity.
• An outward shift in a country’s ‘production possibility curve’ reflects growth of the
economy.

(Real GDP of 𝐘𝟏 – Real GDP of 𝐘𝟎)

Growth Rate (%) = 𝑥 100
Real GDP of 𝐘𝟎
 1.1: ROSTOW’S STAGES OF ECONOMIC GROWTH:
Rostow wrote his classic Stages of Economic Growth in 1960, which presented five steps through
which all countries must pass to become developed:
1) Traditional society,
2) Preconditions to take-off,
3) Take-off,
4) Drive to maturity
5) Age of high mass consumption.

The model asserted that all countries exist somewhere on above line and climb upward through
each stage in the development process:

Traditional Society:
This stage is characterized by
• a agricultural based economy,
• with intensive labour
• low levels of trading,
• a population that does not have a scientific perspective on the world and technology.

Preconditions to Take-off:
under this stage,
• a society begins to develop manufacturing,
• go national/international, as previously it was at regional level.

Take-off:
• It is a short period of intensive growth,
• industrialization begins to occur,
• workers and institutions become concentrated around a new industry.

Drive to Maturity:
This stage takes place over a long period of time,:
• standards of living rise,
• use of technology increases, and
• the national economy grows and diversifies.

Age of High Mass Consumption:

At the time of writing, Rostow believed that Western countries, most notably the United States,
occupied this last "developed" stage. Here, a country's economy flourishes in a capitalist system,
characterized by mass production and consumerism.

1.2: INDICATORS OF GROWTH AND RECESSION:

1. Leading Economic Indicators: (Signal Future Events)

The nature of these indicators is that they are used to forecast at what stage the
economy will be in, at some time in the future. These in particular give an indication
for whether a peak or trough will be reached in the following 3-12 months.
 Indicators Growth Recession
Index of business confidence High Low
Manufacturers’ new orders High Low
New building permits for private housing High Low
Money supply High Low

2. Coincident Economic Indicators: (Ongoing Events)

These indicators are events and measures that occur at the same time as peak or trough
occurs. They are used by governments to assess at what stage the economy is.
Indicators Growth Recession
Number of people in employment High Low
Industrial production High Low
Personal incomes High Low
Manufacturing and trade sales High Low

3. Lagging Economic Indicators: (Based On Events Already Happened)

These indicators are used to assess whether an economy has reached a peak or trough
3-12months after it would have occurred.

Indicators Growth Recession

Consumer Price Index (i.e., measures of inflation) High Low
Average duration of employment High Low
Interest rates High Low
Average income (per capita income) High Low

1.3: COST AND BENEFITS OF ECONOMIC GROWTH:

Advantages/ Benefits: Disadvantages/Costs:

1. Higher living standards: 1. Environmental concerns:
An increase in the real income of the Fast growth may be at the expense of the
individuals in an economy natural environment. Rapid growth can
create negative externalities or e.g., air
pollution, noise pollution, water pollution etc.

2. High employments: 2. Income Inequality

with economic growth, the capacity in an Growth create inequality among
economy increases and therefore there is Economic agent because large fraction of
more opportunity for employment within economic gain goes to only few hands (i.e.,
society. entrepreneur).

3. Fiscal Benefits: 3. Risk of inflation

with higher GDP growth, firms and Average income increases during rapid
individuals will increase the amount of taxes economic growth increase aggregate demand
that they pay. This gives government better which can lead to demand-pull inflation
opportunity to meet their objectives
4. Reduction in poverty: 4. Social Cost
With economic growth, level of poverty Fast economic growth leads to inflation and
decreases. People have more income to meet progressive taxes decrease the ability to meet
their basic needs of life. their basic requirements. To maintain living
standards, people have to work more which
compromises their health and leisure

5. Current account deficit

Economic growth causes an increase in
spending on imports and consequently
observed a current account deficit