its is about Keynesian multiplier effect, accelerator effect and paradox of thrift

1. Keynesianmultipliereffects
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 = ΔY/ΔAE

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)ΔI +(0.6) ΔI+(0.6)2 ΔI+-----
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 ΔY= ΔI . 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
1st round 600 360 120 60 60
2nd round 360 210 72 36 36
3rd 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 E2.
• E2Y2 gives us the new level of
income atY2. It is greater than the
old level of income (Y1) by Y1Y2.
• 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 Y1Y2.

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 Y1 at E1 Y1. When
investment declines from I to K
the income also declines from
Y1 to Y2 and a new equilibrium
E2Y2 is obtained. The incomes
decreases by Y1 Y2 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=ΔY/ΔAE=ΔY/ΔJ
• Consumption multiplier
• Kc=ΔY/ΔC
• Investment multiplier
• KI=ΔY/ΔI
• Govt spending multiplier
• Kg=ΔY/ΔG
• Export multiplier
• Kx=ΔY/ΔX

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)

25. • 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.

26. • 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.

27. • Symbolically
• v= ΔI/ΔC
• Or v. ΔC = ΔI
• V is the accelerator coefficient
• ΔI net change in investment
• ΔC 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

28. • 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.

29. 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

30. • 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.

31. 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

32. 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.

33. 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

34. 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

35. 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..

36. 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

37. • 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.

38. 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.

40. 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.

41. Past paper practice
MCQ

52. NOTE:
As, APC= c/Yd
So, c=C0 +MPC.Yd
Thus by putting c in APC we get:
APC=(C0 +MPC.Yd)/Yd
APC=(C0/Yd ) +MPC
In straight line consumption function MPC is constant but C0/Yd do fall with rise in Yd
In case of increasing or decreasing consumption function APC, because
C0/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=(C0/Yd ) +MPC but here C0/Yd is zero C0 is zero
APC=MPC