Keynesian multiplier and accelerator effects.pptx

Keynesian multiplier, accelerator effects and paradox of thrift

1. Keynesian multiplier effects DR. Arifa Saeed

2. Keynesian multiplier effects Lets say you find a dollar in a street. You now have one dollar that u don’t have before. So this may be an “ income ” of one dollar. What you do with that dollar?? You can spend all of it, or spend some of it and save some of it. You have options…. Lets assume you decided to spend a whole $. Your spending of the $ is an expenditure for you and the income of the person ( enterprenur ) you traded with. How much GDP will increase with that transaction? 1 $(you bought a stuff)

3. Now what to that $ in the possession of the entrepreneur? They have same option which you had: Spend it or save it Lets assume the entrepreneur spend whole $ at an other business this expenditure is now the income of the other person ( enterprenur ) he traded with. How much GDP will increase with that transaction? 1 $

4. This found $ has now purchased $2 worth of goods and services The original $ appears to be cloning itself!! If we repeat this pattern, it would go on FOREVER and GDP would increase infinitely. Is this possible ? WHY? ……….

5. People have tendency to save some of the portion of each $ they receive Keynes have a Fancy Name for this… MPS (tendency to save a portion of each additional $) The flip side of this is people have tendency to spend / consume some portion of each $ they receive Keynes have a Fancy Name for this… MPC (tendency to spend a portion of each additional $ they receive)

6. Example : if I get an additional $, I may consume .90 and save .10 My MPC is 90% and my MSP is 10% if I get an additional $, I may consume .80 and save .20 My MPC is 80 % and my MSP is 20% Do you notice a pattern MPC+MPS=1

7. Lets see how this work in practice Assume the government wants to increase their spending by $ 10 billion Assume MPC of the economy is 90% and 10% is MPS and these must be equal to 100% What will be the effect on GDP when we consider Multiplier effect of each of those $????

8. The government initially spend $10 billion in the economy to purchase goods and services. Does government save any of this money? No they spend whole amount…. What is the immediate effect of this transaction on GDP? It increase by 10 billion $

9. Now what is going to happen to that 10 billion $ now in the hands of the people in the economy? Keynes says people in general will spend 90% and save 10% So when the people spend 90% of 10 billion $ .. How much GDP will increase? $ 9billion Thus with these 2 transactions GDP increase by? $10 billion + $9 billion = $19 billion So that 10 billion $ had a magical effect

10. Now when people who receive the $9 billion, will spend 90% and save 10% GDP is now growing again $10B + $9B + $8.1B = B27.1B NOTE: It does not stop here and this process will go on, until it gets to zero. Thus GDP is now a huge number

11. Keynes come up with simple Mathematics formula. But one this is important, that it was government who started this

12. What Is the Multiplier Effect ? The multiplier principle states that a change in the level of injection or withdrawals brings about a relative greater change in the level of NI An increase in desired AE increases equilibrium NI by a multiple initial increase in autonomous expenditure Multiplier is the ratio of change in income to the change in autonomous expenditure Thus multiplier = K = Δ Y / Δ AE

13. Assumptions There is only autonomous I not any induced I MPC is constant for the whole economy Consumer goods industry have excess capacity to meet the increase in AE No time lags so the process is automatic P is constant economy is working below full employment level

14. Working Of the Multiplier : Suppose I=1000$ into the circular flow Moreover MPC=0.6, MPS=0.2, MPT=0.1 and MPM=0.1 Autonomous I of 1000$ ----raise in first round income by $1000 --- who will 60% (600) as MPC is 0.6 --- this will be received in second round ---- they will also spend 60% (360) as MPC is 0.6 in third round --- so on There will be unlimited rounds of spending leading to aggregate multiplier …. Thus increase in NI is $2500 Y=$1000+$600+$360+---- Y=(1) Δ I +(0.6) Δ I+(0.6) 2 Δ I +----- NOTE As, MPC was 0.6 and therefore 0.6 of all incomes will passed on to create income for someone else If we fallow each series we would find that each successive round of extra income would get smaller but never quite reach zero Such series are called “infinite geometric progression” Thus multiplier common ratio is MPS and its first term is $1 As K=1/(1-MPC )= K=1/( 1-0.6)=2.5 Thus Δ Y= Δ I . K = $1000. 2.5 = $2500

15. example Round of spending Investment Income $ Consumption MCP=0.6 Saving MPS0.2 Tax MPT=0.1 Imports MPM=0.1 Initial stage 1000$ 1000 600 200 100 100 1 st round 600 360 120 60 60 2 nd round 360 210 72 36 36 3 rd round 216 Total 1000 2500 1500 500 250 250

16. Multiplier is a double-edged weapon . It works in the backward direction as much as in the forward direction . The process of income propagation through multiplier does not work in the forward direction only. It is quite possible that it may work in the reverse direction depending upon the direction of the initial change in investment.

17. Multiplier with respect to Keynesian cross For one reason or the other, investment rises from C + I to C + I + I’. The new curve C + I + I’ intersects the 45° line at E 2 . E 2 Y 2  gives us the new level of income atY 2 . It is greater than the old level of income (Y 1 ) by Y 1 Y 2 . This is twice the difference between C + I and C + I + I’ curves. Thus, assuming MPC of 1/2 and, therefore, the multiplier being 2, the original increase in investment leads to double the increase in income Y 1 Y 2 .

18. Multiplier with respect to withdrawals and injection in this figure, the S curve (drawn according to the MPS being ½) is interested by the I curve to give us the equilibrium level of income Y 1  at E 1  Y 1.  When investment declines from I to K the income also declines from Y 1  to Y 2  and a new equilibrium E 2 Y 2  is obtained. The incomes decreases by Y 1  Y 2  i.e., being double the decline in investment.

19. The multiplier formula By infinite geometric progression K=1/(1-MPC) As MPC+MPS+MPT+MPM=1 Therefore 1-MPC=MPS+MPT+MPM=MPW We could also write the formula as K=1 /( 1-MPC)=1/MPW K(2 sector)=1/MPW=1/MPS K(3 sector)=1/MPW=1 /(MPS+MPT) K(4 sector)= 1/MPW=1/(MPS+MPT+ MPM) By definition K= Δ Y/ Δ AE= Δ Y/ Δ J Consumption multiplier Kc= Δ Y/ Δ C Investment multiplier KI= Δ Y/ Δ I Govt spending multiplier Kg= Δ Y/ Δ G Export multiplier Kx = Δ Y/ Δ X

20. Strength of multiplier MPC ( marginal propensity to consume) As we know, K=1 /(1-MPC ) Therefore MPC↑ …. K stronger MPC↓ …. K weaker MPW (marginal propensity to withdraw) As we know, MPW=(1-MPC ) Thus multiplier is directly related to MCP but inversely with MPW MPW=MPS+MPT + MPM ↑ …. K weaker MPW=MPS+MPT+ MPM ↓ …. K Stronger

21. Strength of multiplier Level of employment If level of employment ↓ … (unemployment) ….Y ↓ …. MPC↑ …. K stronger If level of employment ↑ … (low or no unemployment ) ….Y ↑ …. MPC ↓ …. K weaker Poverty in economy High rate of poverty…. Y ↓ …. MPC↑ …. K stronger Low rate of poverty …. Y ↑ …. MPC ↓ …. K weaker

22. Limitations of Multiplier: Efficiency of production:  If the production system of the country cannot cope with increased demand for consumption goods and make them readily available, the incomes generated will not be spent as visualized.   As a result, the mpc may decline. Regular investment:  The value of the multiplier will also depend on regularly repeated investments.  A steadily increasing investment is essential to maintain the tempo of economic activity. Multiplier period:  Successive doses of investment must be injected at suitable intervals if the multiplier effect is not to be lost. Full employment ceiling:  As soon as full employment of the idle resources is achieved, further beneficial effect of the multiplier will practically cease.

23. Past paper questions Analyze how a change to the equilibrium level of income resulting from the multiplier process might lead to unemployment or inflation? (12) in 2002 there were a dangerous virus in china which caused many deaths. By July 2003 china had eliminated the virus and as a result there was a revival of tourism and consumer spending. Retail sales rose at fastest pace for six months. Explain the effect of rise in consumer spending in china’s NI? (12)

24. The Keynesian concept of multiplier states that as the investment increases, income increases by a multiple amount. On the other hand, there is a concept of accelerator which was not taken into account by Keynes which has become popular after Keynes, especially in the discussions of theories of trade cycles and economic growth. The acceleration principle describes the effect quite opposite to that of multiplier. According to this, when income or consumption increases, investment will increase by a multiple amount. When income and therefore consumption of the people increases, the greater amount of the commodities will have to be produced.

25. The multiplier describes the relationship between investment and income, i.e., the effect of investment on income.  The multiplier concept is concerned with original investment as a stimulus to consumption and thereby to income and employment.   But in this concept, we are not concerned about the effect of income on investment.    This effect is covered by the  ‘accelerator’ .  The term  ‘accelerator’  should not be confused with the accelerator in cars.  It does not make the investment to grow faster and faster. The term  ‘accelerator’  is associated with the name of J.M. Clark in the year 1914.  it has been proved a powerful tool of economic analysis since then.  Keynes, astonishingly, has altogether ignored this concept.  That is why, the concept of accelerator is not considered the part of Keynesian theory.

26. Symbolically v= Δ I/ Δ C Or v. Δ C = Δ I V is the accelerator coefficient Δ I net change in investment Δ C net change in Consumption expenditure If increase in C is 10 Crores leads to the increase in I investment 30 crores, the accelerator coefficient is 3

27. According the principle of accelerator, when income increases, people’s spending power increases; their consumption increases and consequently the demand for consumer goods increases.   In order to meet this enhanced demand, investment must increase to raise the productive capacity of the community.   Initially , however, the increased demand will be met by over-working the existing plants and machinery.   All this leads to increase in profits which will induce entrepreneurs to expand their plants by increasing their investments.  Thus a rise in income leads to a further induced investment.  The accelerator is the numerical value of the relation between an increase in income and the resulting increase in investment.

28. Years Demand Required Stock of Capital Replacement Cost Net Investment Gross Investment 2007 500 5 machines 1500 1 machine 300 0 machine 300 2008 500 5 machines 1500 1 machine 300 0 machine 300 2009 800 8 machines 2400 1 machine 300 3 machines 900 1200 2010 1000 10 machines 3000 1 machine 300 2 machines 600 900 2011 1000 10 machines 3000 1 machine 300 0 machine 300 2012 800 8 machines 2400 1 machine 300 – 2 machines 600 – 300

29. In the above example, suppose we are living in a world, where the only commodity produced is cloth.  Further suppose that to produce cloth Rs . 100,000, we require one machine worth Rs . 300,000, which means that the value of the accelerator is 3 (i.e., the capital-output ratio is 1:3).  That is, if demand rises by Rs . 100,000, additional investment worth Rs . 300,000 takes place.  If the existing level of demand for cloth remains constant, let us say, at Rs . 500,000, then to produce this much cloth we need five machines worth Rs . 1.5 million.  At the end of one year, let us suppose, that one machine becomes useless as a result of wear and tear, so that at the end of one year, a gross investment of Rs . 300,000 must take place to replace the old machine in order that the stock of capital is capable of producing output worth Rs . 500,000 . n the third period, i.e., the year 2009, demand rises to Rs . 800,000. To produce output worth Rs . 800,000, we need 8 machines.  But our previous stock consisted of only 5 machines.  Thus if we are to produce output worth Rs . 800,000, we must install 3 new machines, worth Rs . 900,000.  The net investment for the year 2009 will be Rs . 900,000 and with the replacement cost of one machine Rs . 300,000, our gross investment jumps from Rs . 300,000 in the year 2008 to Rs . 1.2 million in the year 2009.  A 60 per cent increase in demand led to a 400 per cent increase in gross investment.  Here we have a glimpse of the powerful destabilising role of accelerator.

30. If Then Because GDP is rising but at the constant rate Induced Investment will not change Is because firm can continue to buy the same number of machines each year to expand capacity GDP is rising but at the increasing rate Induced Investment will increase Is because firm need to buy the additional number of machines each year to meet the production Demand GDP is rising but at the decreasing rate Induced Investment will decrease Is because firm needs to buy less number of machines each year

31. Assumptions of the Accelerator: Under the principle of accelerator, it is assumed that  there is no excess capacity existing in the consumer goods industries .  No machines are lying idle and shift working is not possible. In capital goods industries, it has been assumed that there is an existence of surplus capacity.   If there is no excess capacity in capital goods industries, increased demand for machines could not lead to increase in the supply of machines. Output is flexible.   The machine-making industry or capital goods industry can increase its output whenever desired. The size of the accelerator does not remain constant over time.   It value will be affected by the businessmen’s calculations regarding the profitability of installing new plants to make more machines on the basis of their probable working life. The demand for machines will remain stable in the future,  although the increase in demand has suddenly cropped up.

32. Limitations Increase in the demand for Consumer goods does not always result in greater %age change in demand for capital goods. For instance, firm will not buy more capital goods if they have excess capacity If they do no expect the rise in consumer demand to last If it is not possible for firm to buy many capital goods industries are working close to capacity With advances in technology the capital-output ratio may change with fewer machines being needed to produce a given output

33. Relationship between multiplier and accelerator When economy moves towards boom ΔI↑----- multiplier ----- ΔY↑ ------ accelerator -----ΔI↑----- multiplier ----- ΔY↑ ------ accelerator ----- and so on When economy moves towards recession ΔI↓----- multiplier ----- ΔY ↓ ------ accelerator ----- ΔI ↓ ----- multiplier ----- ΔY ↓ ------ accelerator ----- and so on

34. Paradox of thrift The paradox of thrift refers to a situation in which people tend to save more money, thereby leading to a fall in aggregate savings of the economy as a whole. In other words, when everyone increases their saving-income proportion, MPS, then aggregate demand falls as consumption reduces. This leads to a decrease in the level of employment and income and reduces total savings in the economy. The concept was suggested by Keynes to depict how increased savings at an individual level will gradually lead to a slowdown in the economy. .

35. Understanding the Paradox of Thrift According to Keynesian Theory, the proper response to an economic recession is more spending, more risk-taking, and fewer savings . Keynesians believe a recessed economy does not produce at full capacity because some of its factors of production (land, labor, and capital) are unemployed. Keynesians also argue that consumption, or spending, drives economic growth. Thus, even though it makes sense for individuals and households to reduce consumption during tough times, this is the wrong prescription for the larger economy

36. A pullback in aggregate consumer spending  might force businesses to produce even less, deepening the recession. This disconnect between individual and group rationality is the basis of the savings paradox . An example of this was witnessed during the  Great Recession and financial crisis of 2008. During that time, the savings rate for the average American household increased from 2.9 % to 5%. The federal Reserves   reduced interest rates in order to boost spending in the American economy .

37. Circular flow model Keynes helped revive the  circular flow model  of the economy. This theory states that an increase in current spending drives future spending. Current spending, after all, results in more income for current producers. Those producers rationally deploy their new income, sometimes expanding business and hiring new workers; these new workers earn new income, which then may be spent. To boost current spending, Keynes argued for lower interest rates to lower current  saving rates. If low interest rates do not create more borrowing and spending, Keynes said, the government could engage in  deficit financing  to fill the gap.

38. Limitations of the Paradox of Thrift The circular flow model ignores the lesson of  Says law (supply creates its own demand), which states goods must be produced before they can be exchanged. Capital machines, which drive higher levels of production, require additional savings and investment. The circular flow model only works in a framework without capital goods. Also, the theory ignores the potential for  inflation or deflation. Finally, the paradox of thrift ignores the potential for saved income to be lent out by banks. When some individuals increase their savings, interest rates tend to fall, and banks make additional loans. Keynes met these objections by arguing Say’s law was wrong and prices are too rigid to adjust efficiently. Economists remain divided about sticky prices. It is widely accepted that Keynes misrepresented Say’s law in his refutation.

39. Past paper practice MCQ

40. NOTE: As, APC= c/ Yd So, c=C + MPC.Yd Thus by putting c in APC we get: APC=(C + MPC.Yd )/ Yd APC=( C / Yd ) + MPC In straight line consumption function MPC is constant but C / Yd do fall with rise in Yd In case of increasing or decreasing consumption function APC, because C / Yd do fall with rise in Yd fall in MPC with rise in Yd if there is no autonomous consumption in straight line C function (when C is starting from origin) APC =(C / Yd ) + MPC but here C / Yd is zero C is zero APC=MPC