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If so, then the MEI function ought to shift outwards to the right. This, in turn, implies that investment ought to increase - which leads to another increase in aggregate demand and thus the MEI curve shifts out again, raising investment, etc. As a result, it is easy to conceive that, in situations of unemployment where the multiplier works its magic, investment is actually indeterminate - or rather, an ever-shifting MEI curve could imply that all investment projects will be eventually undertaken and not merely those that are profitable at the given rate of interest since the profitability of projects is itself a function of aggregate demand and thus endogenous to the problem.
There are several conceivable ways of extricating Keynes's theory from this critique, none of which work exactly well. The first is simply to assert that while this ever-shifting MEI problem could be true in the aggregate, it is not true at the individual firm level. If Chrysler builds a new factory and thus pays workers more, its investment injection will not lead to an equivalent increase in demand for Chrysler cars.
Rather, workers can spend their new income on Ford cars, or food or anything else, so that, at least for the Chrysler Corporation, the investment decisions it makes do not lead to one-for-one to increases in the demand for its products. However, one can also reverse this proposition: while this is true for the firm, it is still not true for the aggregate because there are no leakages to the economy.
In other words, the individual firm investment function may continue to be downward sloping, but the aggregate investment function is of a different nature, i. Solving this issue, then, would require a more careful consideration of the issue of aggregation.
Now, Keynes himself appealed to Irving Fisher 's notion - arguing that "Professor Fisher uses his "rate of return over cost" in the same sense and for precisely the same purpose as I employ the "marginal efficiency of capital"" Keynes , p. However, as Garegnani points out, Fisher's bases his downward-sloping investment curve on a diminishing marginal productivity of capital argument - which can only be true if another factor i.
Thus, in an unemployment situation, the purported equivalence between the two concepts is not quite right. Another way of defending the falling MEI curve would be to appeal to the increasing marginal costs of investment , as suggested by Abba Lerner , and later Neoclassical theorists, which may be thought of as arising from the rising supply price of new capital goods e.
Foley and Sidrauski , This is plausible, but one must remember that supply price of capital rises only because there are capacity constraints in the capital goods industry. That implies that either we are at full employment or we are in the very short-run and capacity cannot be increased. Garegnani 's argument that Keynes's theory is supposed to be one of "long run" unemployment equilibrium, therefore would disallow the marginal adjustment cost resolution.
There is one further resolution to the problem: namely, recognizing Michal Kalecki 's " principle of increasing risk ". Kalecki proposed that the more firms invest, the greater their indebtedness and thus the greater the potential loss if their projects fail. Thus, assessments of "profitability" become more and more conservative as firms take on larger and larger debt needed to finance greater and greater investment.
This idea of "increasing risk", then, would be sufficient to yield us a downward sloping MEI curve as it neither relies on full employment nor on short run rigidities arguments. A third objection, perhaps best expressed by Robert Eisner and R. Strotz relates to the rather ad hoc way Keynes dealt with the determination of the expected profits and returns. They argued instead for some carefully prescribed distribution and process of expectation formation. This, of course, is a "Neoclassical" objection - Post Keynesians , such as G.
Shackle , Joan Robinson , Hyman Minsky , Paul Davidson , , and Asimakopulos , have vociferously insisted that there is no ad hoccery there at all. An investment influenced by expected profit or rising levels of income in the economy is termed as induced investment.
The factors that affect profits such as prices, wages, and interest influence induced investment. Likewise, it is also affected by demand. At higher levels of income, consumption expenditure. Increased demand raises the expected profitability of the producers who are consequently induced to make more investment.
Thus, induced investment is positively related to the levels of income in an economy. It increases with the rise in income and falls as income declines. The diagram shows that with the increase in the level of income from Y 1 to Y 2 , the level of induced income also increased from I 1 to I 2.
An investment not influenced by expected profitability of level of income is termed as autonomous investment. It is an investment expenditure made by the government with a view of promoting the level of aggregate demand in the economy. When the level of aggregate demand falls short of the aggregate supply, the government tends to push up the level of aggregate demand through various governmental investment expenditures.
Such investment is thus not influenced by profitability and so is independent of the level of income. OI is the level of autonomous investment and the horizontal line II a indicates the Oi level of investment that remained unaffected by the level of income. Induced investment is influenced by endogenous factors such as income level, propensity to consume, stock of fixed capital, etc. While autonomous investment is influenced by exogenous factors. Since gross investment in the economy is the sum of induced investment and autonomous investment, it is determined by both endogenous and exogenous factors.
According to Keynes, investment rate in the economy is mainly influenced by two factors, marginal efficiency of capital and rate of interest. Marginal efficiency of capital is defined as the productivity of capital. Generally, marginal efficiency of capital shows the cost of capital asset and the expected rate of return from additional investment made.
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He believed the government was in a better position than market forces when it came to creating a robust economy. According to Keynes's theory of fiscal stimulus, an injection of government spending eventually leads to added business activity and even more spending. This theory proposes that spending boosts aggregate output and generates more income. If workers are willing to spend their extra income, the resulting growth in the gross domestic product GDP could be even greater than the initial stimulus amount.
The magnitude of the Keynesian multiplier is directly related to the marginal propensity to consume. Its concept is simple. Spending from one consumer becomes income for a business that then spends on equipment, worker wages, energy, materials, purchased services, taxes and investor returns.
That worker's income can then be spent and the cycle continues. Keynes and his followers believed individuals should save less and spend more, raising their marginal propensity to consume to effect full employment and economic growth. In this theory, one dollar spent in fiscal stimulus eventually creates more than one dollar in growth. This appeared to be a coup for government economists, who could provide justification for politically popular spending projects on a national scale.
This theory was the dominant paradigm in academic economics for decades. Eventually, other economists, such as Milton Friedman and Murray Rothbard , showed that the Keynesian model misrepresented the relationship between savings, investment, and economic growth.
Many economists still rely on multiplier-generated models, although most acknowledge that fiscal stimulus is far less effective than the original multiplier model suggests. The fiscal multiplier commonly associated with the Keynesian theory is one of two broad multipliers in economics. The other multiplier is known as the money multiplier. This multiplier refers to the money-creation process that results from a system of fractional reserve banking. The money multiplier is less controversial than its Keynesian fiscal counterpart.
Keynesian economics focuses on demand-side solutions to recessionary periods. The intervention of government in economic processes is an important part of the Keynesian arsenal for battling unemployment, underemployment, and low economic demand. The emphasis on direct government intervention in the economy often places Keynesian theorists at odds with those who argue for limited government involvement in the markets.
Keynesian theorists argue that economies do not stabilize themselves very quickly and require active intervention that boosts short-term demand in the economy. Wages and employment, they argue, are slower to respond to the needs of the market and require governmental intervention to stay on track. Furthermore they argue, prices also do not react quickly, and only gradually change when monetary policy interventions are made, giving rise to a branch of Keynesian economics known as Monetarism.
If prices are slow to change, this makes it possible to use money supply as a tool and change interest rates to encourage borrowing and lending. Lowering interest rates is one way governments can meaningfully intervene in economic systems, thereby encouraging consumption and investment spending. Short-term demand increases initiated by interest rate cuts reinvigorate the economic system and restore employment and demand for services.
The new economic activity then feeds continued growth and employment. Without intervention, Keynesian theorists believe, this cycle is disrupted and market growth becomes more unstable and prone to excessive fluctuation. Keeping interest rates low is an attempt to stimulate the economic cycle by encouraging businesses and individuals to borrow more money.
They then spend the money they borrow. This new spending stimulates the economy. Lowering interest rates, however, does not always lead directly to economic improvement. Monetarist economists focus on managing the money supply and lower interest rates as a solution to economic woes, but they generally try to avoid the zero-bound problem. As interest rates approach zero, stimulating the economy by lowering interest rates becomes less effective because it reduces the incentive to invest rather than simply hold money in cash or close substitutes like short term Treasuries.
Interest rate manipulation may no longer be enough to generate new economic activity if it cannot spur investment, and the attempt at generating economic recovery may stall completely. This is a type of liquidity trap. When lowering interest rates fails to deliver results, Keynesian economists argue that other strategies must be employed, primarily fiscal policy.
Other interventionist policies include direct control of the labor supply, changing tax rates to increase or decrease the money supply indirectly, changing monetary policy, or placing controls on the supply of goods and services until employment and demand are restored. Fiscal Policy. Your Money. Personal Finance. Your Practice. Popular Courses. Part Of. Introduction to Economics. Economic Concepts and Theories.
Economic Indicators. Real World Economies. Economy Economics. As a result, at point H, output is piling up unsold—not a sustainable state of affairs. Conversely, consider the situation where the level of output is at point L—where real output is lower than the equilibrium.
In that case, the level of aggregate demand in the economy is above the degree line, indicating that the level of aggregate expenditure in the economy is greater than the level of output. When the level of aggregate demand has emptied the store shelves, it cannot be sustained, either.
Firms will respond by increasing their level of production. Thus, the equilibrium must be the point where the amount produced and the amount spent are in balance, at the intersection of the aggregate expenditure function and the degree line.
The Keynesian model assumes that there is some level of consumption even without income. Assume that taxes are 0. Let the marginal propensity to save of after-tax income be 0. Given these values, you need to complete Table Calculate after-tax income by subtracting the tax amount from national income for each level of national income using the following as an example:. Calculate consumption. The marginal propensity to save is given as 0. This means that the marginal propensity to consume is 0.
Therefore, multiply 0. As mentioned earlier, the Keynesian model assumes that there is some level of consumption even without income. Step 5. There is now enough information to write the consumption function. The consumption function is found by figuring out the level of consumption that will happen when income is zero.
Let C represent the consumption function, Y represent national income, and T represent taxes. Use the consumption function to find consumption at each level of national income. Add investment I , government spending G , and exports X. Remember that these do not change as national income changes:. Step 8. Find imports, which are 0. For example:. Your completed table should look like Table Answer the question: What is equilibrium?
Find equilibrium mathematically, knowing that national income is equal to aggregate expenditure. Answer this question: How do expenditures and output compare at this point? Aggregate expenditures cannot exceed output GDP in the long run, since there would not be enough goods to be bought. In the Keynesian cross diagram, if the aggregate expenditure line intersects the degree line at the level of potential GDP, then the economy is in sound shape.
There is no recession, and unemployment is low. But there is no guarantee that the equilibrium will occur at the potential GDP level of output. The equilibrium might be higher or lower. For example, Figure In this situation, the level of aggregate expenditure is too low for GDP to reach its full employment level, and unemployment will occur. Because the equilibrium level of real GDP is so low, firms will not wish to hire the full employment number of workers, and unemployment will be high.
What might cause a recessionary gap? Anything that shifts the aggregate expenditure line down is a potential cause of recession, including a decline in consumption, a rise in savings, a fall in investment, a drop in government spending or a rise in taxes, or a fall in exports or a rise in imports. Moreover, an economy that is at equilibrium with a recessionary gap may just stay there and suffer high unemployment for a long time; remember, the meaning of equilibrium is that there is no particular adjustment of prices or quantities in the economy to chase the recession away.
The appropriate response to a recessionary gap is for the government to reduce taxes or increase spending so that the aggregate expenditure function shifts up from AE 0 to AE 1. Conversely, Figure The inflationary gap also requires a bit of interpreting. This implication is clearly wrong. An economy faces some supply-side limits on how much it can produce at a given time with its existing quantities of workers, physical and human capital, technology, and market institutions.
The inflationary gap should be interpreted, not as a literal prediction of how large real GDP will be, but as a statement of how much extra aggregate expenditure is in the economy beyond what is needed to reach potential GDP. An inflationary gap suggests that because the economy cannot produce enough goods and services to absorb this level of aggregate expenditures, the spending will instead cause an inflationary increase in the price level.
In this way, even though changes in the price level do not appear explicitly in the Keynesian cross equation, the notion of inflation is implicit in the concept of the inflationary gap. The appropriate Keynesian response to an inflationary gap is shown in Figure If AE 0 shifts down to AE 1 , so that the new equilibrium is at E 1 , then the economy will be at potential GDP without pressures for inflationary price increases.
The government can achieve a downward shift in aggregate expenditure by increasing taxes on consumers or firms, or by reducing government expenditures. The Keynesian policy prescription has one final twist. By how much does government spending need to be increased so that the economy reaches the full employment GDP? But that answer is incorrect. The reason is that a change in aggregate expenditures circles through the economy: households buy from firms, firms pay workers and suppliers, workers and suppliers buy goods from other firms, those firms pay their workers and suppliers, and so on.
In this way, the original change in aggregate expenditures is actually spent more than once. This is called the multiplier effect: An initial increase in spending, cycles repeatedly through the economy and has a larger impact than the initial dollar amount spent. As shown in the calculations in Figure The additional boost to aggregate expenditures is shrinking in each round of consumption. After about 10 rounds, the additional increments are very small indeed—nearly invisible to the naked eye.
After 30 rounds, the additional increments in each round are so small that they have no practical consequence. Fortunately for everyone who is not carrying around a computer with a spreadsheet program to project the impact of an original increase in expenditures over 20, 50, or rounds of spending, there is a formula for calculating the multiplier. The data from Figure Therefore, the spending multiplier is:. Not coincidentally, this result is exactly what was calculated in Figure The size of the multiplier is determined by what proportion of the marginal dollar of income goes into taxes, saving, and imports.
If the leakages are relatively small, then each successive round of the multiplier effect will have larger amounts of demand, and the multiplier will be high. Conversely, if the leakages are relatively large, then any initial change in demand will diminish more quickly in the second, third, and later rounds, and the multiplier will be small. Changes in the size of the leakages—a change in the marginal propensity to save, the tax rate, or the marginal propensity to import—will change the size of the multiplier.
The multiplier effect is also visible on the Keynesian cross diagram. The rise in real GDP is more than double the rise in the aggregate expenditure function. Similarly, if you look back at Figure Again, this is the multiplier effect at work. In this way, the power of the multiplier is apparent in the income—expenditure graph, as well as in the arithmetic calculation. The multiplier does not just affect government spending, but applies to any change in the economy.
Say that business confidence declines and investment falls off, or that the economy of a leading trading partner slows down so that export sales decline. These changes will reduce aggregate expenditures, and then will have an even larger effect on real GDP because of the multiplier effect. Read the following Clear It Up feature to learn how the multiplier effect can be applied to analyze the economic impact of professional sports.
Attracting professional sports teams and building sports stadiums to create jobs and stimulate business growth is an economic development strategy adopted by many communities throughout the United States. Siegfried and Zimbalist used the multiplier to analyze this issue. They considered the amount of taxes paid and dollars spent locally to see if there was a positive multiplier effect. One can think of spending outside a local economy, in this example, as the equivalent of imported goods for the national economy.
Now, consider the impact of money spent at local entertainment venues other than professional sports. While the owners of these other businesses may be comfortably middle-income, few of them are in the economic stratosphere of professional athletes. If these general assumptions hold true, then money spent on professional sports will have less local economic impact than money spent on other forms of entertainment.
For professional athletes, out of a dollar earned, 40 cents goes to taxes, leaving 60 cents. Of that 60 cents, one-third is saved, leaving 40 cents, and half is spent outside the area, leaving 20 cents. Only 20 cents of each dollar is cycled into the local economy in the first round. For locally-owned entertainment, out of a dollar earned, 35 cents goes to taxes, leaving 65 cents.
Siegfried and Zimbalist make the plausible argument that, within their household budgets, people have a fixed amount to spend on entertainment. If this assumption holds true, then money spent attending professional sports events is money that was not spent on other entertainment options in a given metropolitan area. Since the multiplier is lower for professional sports than for other local entertainment options, the arrival of professional sports to a city would reallocate entertainment spending in a way that causes the local economy to shrink, rather than to grow.
Thus, their findings seem to confirm what Joyner reports and what newspapers across the country are reporting. Is an economy healthier with a high multiplier or a low one? With a high multiplier, any change in aggregate demand will tend to be substantially magnified, and so the economy will be more unstable.
With a low multiplier, by contrast, changes in aggregate demand will not be multiplied much, so the economy will tend to be more stable. However, with a low multiplier, government policy changes in taxes or spending will tend to have less impact on the equilibrium level of real output.
With a higher multiplier, government policies to raise or reduce aggregate expenditures will have a larger effect. Thus, a low multiplier means a more stable economy, but also weaker government macroeconomic policy, while a high multiplier means a more volatile economy, but also an economy in which government macroeconomic policy is more powerful.
Want to cite, share, or modify this book? This book is Creative Commons Attribution License 4. Skip to Content. Table of contents. My highlights. Answer Key. The Axes of the Expenditure-Output Diagram The expenditure-output model, sometimes also called the Keynesian cross diagram, determines the equilibrium level of real GDP by the point where the total or aggregate expenditures in the economy are equal to the amount of output produced.
A vertical line shows potential GDP where full employment occurs. The degree line shows all points where aggregate expenditures and output are equal. The aggregate expenditure schedule shows how total spending or aggregate expenditure increases as output or real GDP rises. The intersection of the aggregate expenditure schedule and the degree line will be the equilibrium. Equilibrium occurs at E 0 , where aggregate expenditure AE 0 is equal to the output level Y 0.
Output on the horizontal axis is conceptually the same as national income, since the value of all final output that is produced and sold must be income to someone, somewhere in the economy. In this example, investment expenditures are at a level of However, changes in factors like technological opportunities, expectations about near-term economic growth, and interest rates would all cause the investment function to shift up or down.
Thus, government spending is drawn as a horizontal line. In this example, government spending is at a level of 1, Congressional decisions to increase government spending will cause this horizontal line to shift up, while decisions to reduce spending would cause it to shift down. The lower line shows the consumption function if taxes must first be paid on income, and then consumption is based on after-tax income. In this example, exports are set at However, exports can shift up or down, depending on buying patterns in other countries.
In this example, the marginal propensity to import is 0. Using an Algebraic Approach to the Expenditure-Output Model In the expenditure-output or Keynesian cross model, the equilibrium occurs where the aggregate expenditure line AE line crosses the degree line.
This pattern cannot hold, because it would mean that goods are produced but piling up unsold. If output was below the equilibrium level at L, then aggregate expenditure would be greater than output. This pattern cannot hold either, because it would mean that spending exceeds the number of goods being produced. Only point E can be at equilibrium, where output, or national income and aggregate expenditure, are equal. The equilibrium E must lie on the degree line, which is the set of points where national income and aggregate expenditure are equal.
Finding Equilibrium Table What is the equilibrium? How do expenditures and output compare at this point? The policy solution to a recessionary gap is to shift the aggregate expenditure schedule up from AE 0 to AE 1 , using policies like tax cuts or government spending increases. Then the new equilibrium E 1 occurs at potential GDP. The policy solution to an inflationary gap is to shift the aggregate expenditure schedule down from AE 0 to AE 1 , using policies like tax increases or spending cuts.
Then, the new equilibrium E 1 occurs at potential GDP.
Keynesian economics represented a new way of looking at spending, output, and inflation. Previously, what Keynes dubbed classical economic thinking held that cyclical swings in employment and economic output create profit opportunities that individuals and entrepreneurs would have an incentive to pursue, and in so doing correct the imbalances in the economy.
A lower level of inflation and wages would induce employers to make capital investments and employ more people, stimulating employment and restoring economic growth. Keynes believed that the depth and persistence of the Great Depression, however, severely tested this hypothesis. In his book, The General Theory of Employment, Interest, and Money and other works, Keynes argued against his construction of classical theory, that during recessions business pessimism and certain characteristics of market economies would exacerbate economic weakness and cause aggregate demand to plunge further.
For example, Keynesian economics disputes the notion held by some economists that lower wages can restore full employment because labor demand curves slope downward like any other normal demand curve. Instead he argued that employers will not add employees to produce goods that cannot be sold because demand for their products is weak.
Similarly, poor business conditions may cause companies to reduce capital investment , rather than take advantage of lower prices to invest in new plants and equipment. This would also have the effect of reducing overall expenditures and employment. Keynesian economics is sometimes referred to as "depression economics," as Keynes's General Theory was written during a time of deep depression not only in his native land of the United Kingdom but worldwide. Other economists had argued that in the wake of any widespread downturn in the economy, businesses and investors taking advantage of lower input prices in pursuit of their own self-interest would return output and prices to a state of equilibrium , unless otherwise prevented from doing so.
Keynes believed that the Great Depression seemed to counter this theory. Output was low and unemployment remained high during this time. The Great Depression inspired Keynes to think differently about the nature of the economy. From these theories, he established real-world applications that could have implications for a society in economic crisis.
Keynes rejected the idea that the economy would return to a natural state of equilibrium. Instead, he argued that once an economic downturn sets in, for whatever reason, the fear and gloom that it engenders among businesses and investors will tend to become self-fulfilling and can lead to a sustained period of depressed economic activity and unemployment.
In response to this, Keynes advocated a countercyclical fiscal policy in which, during periods of economic woe, the government should undertake deficit spending to make up for the decline in investment and boost consumer spending in order to stabilize aggregate demand.
Keynes was highly critical of the British government at the time. The government greatly increased welfare spending and raised taxes to balance the national books. Keynes said this would not encourage people to spend their money, thereby leaving the economy unstimulated and unable to recover and return to a successful state. Instead, he proposed that the government spend more money and cut taxes to turn a budget deficit, which would increase consumer demand in the economy.
This would, in turn, lead to an increase in overall economic activity and a reduction in unemployment. Keynes also criticized the idea of excessive saving, unless it was for a specific purpose such as retirement or education. He saw it as dangerous for the economy because the more money sitting stagnant, the less money in the economy stimulating growth.
This was another of Keynes's theories geared toward preventing deep economic depressions. Many economists have criticized Keynes's approach. They argue that businesses responding to economic incentives will tend to return the economy to a state of equilibrium unless the government prevents them from doing so by interfering with prices and wages, making it appear as though the market is self-regulating.
On the other hand, Keynes, who was writing while the world was mired in a period of deep economic depression, was not as optimistic about the natural equilibrium of the market. He believed the government was in a better position than market forces when it came to creating a robust economy.
According to Keynes's theory of fiscal stimulus, an injection of government spending eventually leads to added business activity and even more spending. This theory proposes that spending boosts aggregate output and generates more income. If workers are willing to spend their extra income, the resulting growth in the gross domestic product GDP could be even greater than the initial stimulus amount. The magnitude of the Keynesian multiplier is directly related to the marginal propensity to consume.
Its concept is simple. Spending from one consumer becomes income for a business that then spends on equipment, worker wages, energy, materials, purchased services, taxes and investor returns. That worker's income can then be spent and the cycle continues. Keynes and his followers believed individuals should save less and spend more, raising their marginal propensity to consume to effect full employment and economic growth. In this theory, one dollar spent in fiscal stimulus eventually creates more than one dollar in growth.
This appeared to be a coup for government economists, who could provide justification for politically popular spending projects on a national scale. This theory was the dominant paradigm in academic economics for decades. Eventually, other economists, such as Milton Friedman and Murray Rothbard , showed that the Keynesian model misrepresented the relationship between savings, investment, and economic growth.
Many economists still rely on multiplier-generated models, although most acknowledge that fiscal stimulus is far less effective than the original multiplier model suggests. The fiscal multiplier commonly associated with the Keynesian theory is one of two broad multipliers in economics.
The other multiplier is known as the money multiplier. This multiplier refers to the money-creation process that results from a system of fractional reserve banking. The money multiplier is less controversial than its Keynesian fiscal counterpart. Keynesian economics focuses on demand-side solutions to recessionary periods. The intervention of government in economic processes is an important part of the Keynesian arsenal for battling unemployment, underemployment, and low economic demand.
The emphasis on direct government intervention in the economy often places Keynesian theorists at odds with those who argue for limited government involvement in the markets. Consequently, the size of multiplier is smaller than that of simple Keynesian multiplier with a given fixed price level. This is because a part of expansionary effect of GNP of the increase in autonomous government expenditure is offset by rise in the price level.
The multiplier effect in case of upward sloping curve is shown in Fig. To begin with, in the top panel of Fig. In the panel at the bottom of Fig. Now suppose autonomous investment expenditure which is independent of changes in price level increases by AI. As will be seen from the lower panel b of Fig. Now, with this rise in price level to P 1 , aggregate expenditure curve in the upper panel a will not remain unaffected but will shift downward. This fall in aggregate expenditure curve is due to the adverse effects on wealth or real balances, interest rate and net exports.
Much of wealth is held in the form of bank deposits, bonds and shares of companies and other assets. With the rise in price level, real value or purchasing power of wealth possessed by the people declines. This induces them to spend less. As a result, consumption expenditure declines due to this wealth effect. Given the demand function for money M d , the decline in the real money supply will cause rate of interest to rise. Now, the rise in interest will induce private investment expenditure to decline.
Lastly, rise in price level in the domestic economy will adversely affect exports of a country causing net exports to fall. Thus, as a result of negative effects of rise in price level on real wealth, private investment and net exports, in the upper panel a of Fig. Thus with the upward sloping short-run aggregate supply curve SAS, the effect of increase in autonomous investment expenditure or for that matter increase in any other autonomous expenditure such as Government expenditure, net exports, autonomous consumption on the GNP level can be visualized to occur in two stages.
First, increase in investment expenditure shifts aggregate expenditure curve AE upward in the upper panel a of Fig. However, as shall be seen from Fig. It may be further noted that steeper the slope of the short- run supply curve, the greater is the increase in the price level and smaller is the effect on real GNP. Multiplier is one of the most important concepts developed by J. Keynes to explain the determination of income and employment in an economy.
The theory of multiplier has been used to explain the cumulative upward and downward swings of the trade cycles that occur in a free-enterprise capitalist economy. When investment in an economy rises, it has a multiple and cumulative effect on national income, output and employment. As a result, economy experiences rapid upward movement.
On the other hand, when due to some reasons, especially due to the adverse change in the expectations of the business class, investment falls, then backward working of the multiplier causes a multiple and cumulative fall in income, output and employment and as a result the economy rapidly moves on downswing of the trade cycle.
Thus, Keynesian theory of multiplier helps a good deal in explaining the movements of trade cycles or fluctuations in the economy. The theory of multiplier has also a great practical importance in the field of fiscal policy to be pursued by the Government to get out of the depression and achieve the state of full employment.
To get rid of depression and remove unemployment, Government investment in public works was recommended even before Keynes. But it was thought that the increase in income will be limited to the amount of investment undertaken in these public works. But the importance of public works is enhanced when it is realised that the total effect on income, output and employment as a result of some initial investment has a multiplier effect. Thus, Keynes recommended Government investment in public works to solve the problem of depression and unemployment.
The public investment in public works such as road building, construction of hospitals, schools, irrigation facilities will raise aggregate demand by a multiple amount. The multiple increase in income and demand will also encourage the increase in private investment. Thus, the deficiency in private investment which leads to the state of depression and underemployment equilibrium will now be made up and a state of full employment will be restored.
If the multiplier had not worked, the income and demand would have risen as a result of some public investment but not as much as they rise with the multiplier effect. Inspired by the Keynesian theory of multiplier, expansionary fiscal policy of increase in Government expenditure and reduction in income tax have been adopted by President John Kennedy and President George W.
Bush in the United States of America to remove involuntary unemployment and depression. Suppose the level of autonomous investment in an economy is Rs. The size of multiple is determined by the value of marginal propensity to consume. Thus, with increase in investment by Rs. Suppose in a country investment increases by Rs. How much increase will there take place in income? An interesting paradox arises when all people in a society try to save more but in fact they are unable to do so.
The multiplier theory of Keynes helps a good deal in explaining this paradox. According to this paradox of thrift, the attempt by the people as a whole to save more for hard times such as impending period of recession or unemployment may not materialize and in their bid to save more the society in-fact may not only end up with the same savings or, even lower savings but also in the process cause their consumption or standard of living to decline.
Thrift i. Further, according to classical economists, savings determine investment which plays a crucial role in accelerating the rate of economic growth. However, the paradox of thrift shows that the efforts to. It goes to the credit of Keynes that with his multiplier theory he was able to resolve the paradox of thrift. Keynesian explanation of paradox of thrift has been shown in Fig. Keynes has showed that if all people in a society decide to save more, they may actually fail to do so but nevertheless reduce their consumption.
This is because, according to Keynes, the effort to save more by all in a society will lower the aggregate demand for goods and services resulting in a drop in the level of national income. At the lower level of national income, the savings fall to the original level but consumption will be less than before which implies that the people would become worse off. Consider Fig. It will be seen that saving and investment curves intersect at point E and determine level of income equal to K, or Rs.
Now suppose that expecting hard times ahead all people try to save more by the amount of Rs. This downward shift in the consumption function brings about an upward shift by Rs. It is important to note that level of income does not drop only by the amount E 1 A or RS. With marginal propensity to save MPS being equal to 0. Further, the decline in consumption due to more saving would cause the multiplier to work in reverse, that is, the multiplier would operate to reduce the level of consumption and income by a magnified amount.
The decline in consumption expenditure of the people by Rs. But the reverse process will not stop here. Given the marginal propensity to consume being equal to 0. It will be observed from Fig. Thus the attempt by all people to save more has led to the decline in the equilibrium level of income to Y 2 or Rs. This is clearly depicted in Fig. With the decrease in planned saving by Rs.
This sets in motion the operation of the multiplier in the reverse and as will be seen from the It is important to observe that the saving which had risen to Y 1 A Rs. In other words, the increases in saving by Rs. This explains the paradoxical feature of an economy gripped by recession. This is paradoxical because in their attempt to save more the people have caused a decline in their income and consumption with no increase in the saving of the society at all.
In our analysis we have assumed that the planned investment is fixed, that is, determined outside the model. In other words, the investment has been assumed to be autonomous of income, that is, it does not vary with income. Paradox of thrift holds good when a free market economy is in the grip of recession or depression and investment demand is inadequate due to lack of profit opportunities.
However, it has been pointed out by some economists that paradox of thrift can be averted if the extra savings that the people do for a rainy day are somehow channeled into additional investment through financial markets. Indeed, the classical economists argued that the increase in the supply of savings would lead to the fall in the rate of interest which would induce increase in planned investment.
In Fig. In this way the paradox of thrift has been averted. However, according to the modern economists, especially the followers of Keynes, the empirical evidence does not support the above argument of averting the paradox of thrift. This is because at times of recession or depression, the prospective yields from investment are so small that no possible reduction in the rate of interest will induce sufficient increase in investment.
Thus, according to them, in a free-market and private enterprise economy without Government intervention paradox of thrift cannot be averted. Of course, if the Government intervenes as it does even in the present- day predominantly private enterprise economies of the USA and Great Britain, it can mobilise the extra savings of the people and invest them in some worthwhile projects and thus prevent aggregate demand and income from falling. This can happen because the Government undertakes investment because it is not motivated by profit motive but by the considerations of promoting social interest and economic growth.
It is because of this that the role of the Government has greatly increased for overcoming recession in the capitalist countries. During the s the capitalist economies experienced severe depression which caused widespread involuntary unemployment, substantial loss of output and income and crushing hunger and poverty among the working classes. The classical economists attributed this unemployment and depression to the higher wage rates maintained by the trade unions and the Government.
However, this explanation did not prove to be valid. It was English economist J. Keynes who radically departed from the classical thought and put forward the view that it was the large decline in investment that caused the depression and substantial increase in involuntary unemployment. According to Keynes, the investment was highly volatile and it was a drastic decline in it due to the pessimistic expectations of the entrepreneurs about the prospective profits from investment that brought about a decline in aggregate demand expenditure which through working of the multiplier in the reverse caused a magnified fall in income output and employment.
For example, during the first four years of depression in the USA the unemployment which was only 3. The huge decline in national income and the emergence of unemployment in the USA, UK and other industrialized capitalist countries during the period of depression is graphically shown in Fig. The important point made by Keynes was that income would not fall merely equal to the decline in investment but by a multiple of it. In fact, during the depression period of s, it actually happened so and is evident from Table It will be seen from Figure Y F Y 1 is twice that of HT.
This is due to the working of multiplier in the reverse. Further note that after taking into all leakages in the multiplier process it has been assumed that marginal propensity to consume is equal to 0. Now, the historical record of this period about the various components of aggregate demand of the US economy shows that changes in net exports and Government expenditure were quite small and they mostly offset each other during the period It has been estimated that taking into account all leakages in the multiplier process, the value of the multiplier was around 2 during the period.
This is in accordance with the value of multiplier being equal to around 2. Multiplier is here equal to. Thus, the Keynesian theory of income determination provides a fairly accurate explanation of the first four years of the great depression. This looks rather simple but during the early s it was not understood at all.
Only after the Keynesian prescription to ward off depression and involuntary unemployment, namely, launching by the Government public works programme financed by the deficit budgets to raise aggregate demand, such as adopted under New Deal Policy in the U. An important result of the success of the Keynesian model was that fiscal policy as an instrument for controlling business cycles came into prominence.
Further, it now became clear that the Government intervention, through the adoption of appropriate fiscal and monetary policies, can avert the collapse of the economy such as that happened during In the early fifties an eminent Indian economist Dr.
Rao and some others explained that in developing countries like India Keynesian multiplier did not work in real terms, that is, does not operate to increase income and employment by a multiple of the initial increase in investment. He claimed that the concept of investment multiplier was valid in the context of the situation of depression in the industrialized developed economies of the UK and the USA where there existed a lot of excess productive capacity and a larger number of open involuntary unemployment.
He argued that in such a situation of a depressed economy there was a high elasticity of supply of output to changes in demand for them. Therefore, in the developed capitalist economies ridden with depression increase in investment leading to successive rounds of consumption expenditure raises aggregate demand. Due to the existence of large excess capacity and involuntary unemployment under conditions of depression aggregate supply of outputs highly elastic, increase in aggregate demand brings about increase in real income, output and employment which is a multiple of original increase in investment.
On the other hand, they claimed that in underdeveloped countries there was little excess capacity in consumer goods industries and therefore supply of output was inelastic. Therefore, when there is injection of investment, and as a result through successive rounds of the operation of multiplier, aggregate demand for consumer goods increases, it results mainly in rise in money income brought about through rise in prices and not an increase in real national income.
The second condition, according to Dr. Rao and his followers, for the working of multiplier in raising national income and employment was that the supply of raw materials, financial capital must be sufficiently elastic so that when aggregate demand increases as a result of multiplier effect of increase in investment the supply of output could be increased adequately to meet this higher demand for goods and services. They argued that in underdeveloped countries like India due to under developed nature of their economies, there was acute scarcity of raw materials, other intermediate goods such as steel, cement and financial capital which put great obstacles for the working of multiplier in real terms.
The third condition required for the working of multiplier in real terms was that there should be involuntary open unemployment so that when aggregate demand for goods increases as a consequence of new investment, the adequate supply of workers must be forthcoming to be employed in the production processes of various industries.
They argued this condition too was not fulfilled in the under developed countries where there existed disguised unemployment, especially in the agricultural sector. The disguisedly unemployed workers who are supported by joint family system could not be easily shifted to be employed in the industries for expansion of output to achieve the multiplier effect.
Lastly, it was pointed out that the under developed countries like India had predominantly agricultural economies and income elasticity of demand for food grains was very high in these economies. In view of this when increase in investment leads to the rise in money incomes of the people, a large part is spent on food grains.
But the supply of agricultural products is inelastic because their production is subject to uncertain natural factors like monsoon and climate and further there was lack of irrigation facilities, improved seeds, fertilizers etc.
Hence it was difficult to increase agricultural production in response to the increase in demand through the multiplier effect of increase in investment. It follows from above that the Keynesian assumptions for the working of multiplier in real terms, namely:.
In view of the earlier economists these assumptions for realizing the multiplier effect in terms of rise in real income and employment were not valid in case of under developed countries. Therefore, according to them, Keynesian multiplier did not operate in real terms in under developed countries and actually leads to the rise in price or inflationary conditions in them.
We have explained above the views of some eminent Indian economists, such Dr. Rao, Dr. Dass Gupta, expressed during the early fifties regarding non-operation of the Keynesian multiplier in the under developed countries.
But the situation in the present-day developing countries has substantially changed in the last 60 years. There has been a lot of economic growth and structural transformation in the Indian economy during the last half a century so that supply conditions today have become significantly elastic.
So in the present state of the Indian economy and also of some other developing economies, it cannot be said that Keynesian multiplier is not applicable in real terms in them. However, it may be noted that even in the fifties and early sixties the view that Keynesian multiplier did not work in the under developed countries did not go entirely unchallenged.
Thus commenting on Dr. Similarly, Dr. At present, in the beginning of the new millennium as a result of economic growth both in the industrial and agricultural sectors the Indian economy has a widely diversified structure and supply of output has become quite elastic, at least in the industrial sector. Besides, at times there is a lot of excess or unutilized capacity in several industries in India due to the deficiency of aggregate demand. The potential for increasing raw materials and intermediate products such as cement, steel and fertilizers has significantly increased to meet the rising demand for them.
If there is injection of investment it will result in manifold increase in output or real income and employment through the working of the multiplier. If the injection of new investment package is quite diversified and balanced, as is generally planned in our Five Year Plans, the investment and growth in several industries simultaneously will create not only additional demand for each other as was visualized by Nurkse but will also create productive capacities in them which will ultimately over a period of result in multiple increase in output and employment.
It is worth noting that in India today there is not only a lot of preexisting excess production capacity in the Indian industries but new investment every year also creates additional production capacity which with some time-lag will result in increase in real income or output, if adequate aggregate demand is forthcoming for its utilisation. Harrod-Domar in their famous dynamic growth models emphasized that investment not only creates demand but also new productive capacity.
Thus, if we look at increment in investment from the viewpoint of dynamics of development and take a longer time horizon, multiplier effect of new investment in the developing countries can become a reality. It is true that increase in money incomes and demand may tend to occur ahead of the increase in real income but subject to some time-lag between investment and consequent increase in production capacity, the latter would tend to catch up with the former.
The significant point to note is that investment not only creates demand but it also creates production capacity. Ultimately there is no reason as to why multiplier effect of new investment on real income or output may not materialize, though the actual period required for realisation of the multiplier effect depends on various time-lags in the process of income generation and capacity creation.
The wider the range to industries over which initial investment is undertaken, the greater will be the multiplier effect.
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