Price inflation constitutes another important leakage in the working of the multiplier process in real terms. 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. Thus, while the availability of the factors of production determines a nation’s potential GDP, the amount of goods and services actually being sold, known as real GDP, depends on how much demand exists across the economy. With the rise in price level, real value or purchasing power of wealth possessed by the people declines. 10.2 will reveal that the increase in income Y1 Y2 is greater than the increase in investment by II”. If the market rate of interest is 10%, is it to your advantage to purchase the asset? 2. This is because the demand for capital (investment) goods is a derived (indirect) demand. Thus the Keynesians economists claim that monetary policy will not be very effective in influencing the level of investment in the economy. 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. In the Indian economy today there are a large number of involuntarily unemployed workers crying out for employment. The sharp decline in investment by the amount HT due to the fall in profitability of investment following a crash in stock markets in 1929 and other unfavourable events caused a downward shift in the aggregate demand curve to C +I1 (where I1 < I2). The multiplier will be 1/0.2 or 1/2/10 = Likewise if marginal propensity to consume (b) is 0.75, marginal propensity to save will be 1 – 0.75 = 0.25 and multiplier will be 1/0.25 = 1/25/100 = 4. With short-run aggregate supply curve sloping upward, a rightward shift in aggregate demand curve raises new equilibrium GNP level not equal to the horizontal shift in the aggregate demand curve but less than it. keynesian … If these leakages are plugged, the effect of change in investment on income and employment would be greater. TOS4. Secondly, the rise in price level reduces the supply of real money balances (Ms/P) that causes a shift in money supply curve to the left. In the lower panel (b), due to the upward shift in aggregate expenditure curve, aggregate demand curve shifts rightward from AD to AD1The horizontal shift in the aggregate demand curve at a given price level is determined by the increase in aggregate expenditure multiplied by the simple Keynesian multiplier at the given fixed price level (B’H or ∆Y = ∆I 1/1- MPC) But given the upward sloping short-run aggregate supply curve SAS with new aggregate demand curve AD1, price level does not remain fixed. 80 crores. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. This will reduce the value of the multiplier. In other words, multiple increment in income as a result of a given net increase in investment does not only take place in money terms but also in terms of real output, that is, in terms of goods and services. They argued this condition too was not fulfilled in the under developed countries where there existed disguised unemployment, especially in the agricultural sector. If it is an open economy as is usually the case, then a part of increment in income will also be spent on the imports of consumer goods. 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. However, the marginal propensity to consume may differ in various rounds of consumption expenditure. In the simple Keynesian model of income determination, change in investment is considered to be autonomous or independent of changes in income while changes in consumption are function of changes in income. Even a change in one the components will cause total output to change. 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. In this case the economic life of the machine (which depends on the annual rate of depreciation) is not known. In other words, there will be more demand for food-producing and textile-producing machines. 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. Raj remarked that “Discarding the Keynesian thesis as altogether inoperative in under developed countries is really throwing the baby away with the bath water”. 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. Privacy Policy3. 10.3 the corresponding aggregate demand curve AD0 and the short-run aggregate supply curve SAS intersect at B’ at the above determined GNP level K0. Ramesh singh chapter 5, Visvesvaraya plan, Gandhi plan, Bombay plan , Sarvodaya plan for upsc IAS - Duration: 21:09. According to Keynes investment decisions are taken by comparing the marginal efficiency of capital (MEC) or the yield with the real rate […] 585 at the end of the first year and Rs. A part of the increment in income is used for paying back the debts which the people have taken from moneylenders, banks or other financial institutions. 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. In other words, the investment has been assumed to be autonomous of income, that is, it does not vary with income. But this is not all. Share Your Word File Thus, monetarists claim that monetary policy will be effective in influencing the level of investment. The multiplier works in real terms only when as a result of increase in money income and aggregate demand, output of consumer goods is also increased. The essence of multiplier is that total increase in income, output or employment is manifold the original increase in investment. In the early fifties an eminent Indian economist Dr. V.K. 10.4. In this figure SS is the saving curve indicating that as the level of income increases, the community plans to save more. Further, we have assumed that there is no any time-lag between the increase in investment and the resultant increment in income. This is due to the working of multiplier in the reverse. The multiplier can be derived algebraically as follows: Writing the equation for the equilibrium level of income we have, As in the multiplier analysis we are concerned with changes in income induced by changes in investment, rewriting the equation (1) in terms of changes in the variables we have. ADVERTISEMENTS: Let us make an in-depth study of the Keynesian Theory of Investment. How much increase in national income will take place as a result of an initial increase in investment can be expressed in the following mathematical form: It is thus clear that if the marginal propensity to consume is 4/5, the investment of Rs. The conventional view of Keynes' theory of investment is that additions to the stock of plant and equipment depend on both the interest rate and the marginal efficiency of investment (MEI). 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. In our analysis we have assumed that the planned investment is fixed, that is, determined outside the model. In recent years, the importance of time-lag has been recognized and concept of dynamic multiplier has been developed on that basis. In this way increase in demand resulting from investment would not lead to rise in prices but will cause real output to rise. Suppose marginal propensity to save of an open economy is 1/4, i.e., marginal propensity to consume is 3/4. Share Your PDF File Disclaimer Copyright, Share Your Knowledge Kahn in the early 1930s. S = f (Y). We know that. Abstract. achievment of full employment vii. Therefore, change in consumption can occur only if there is change in income. For example, if investment equal to Rs. In fact the income-expenditure approach (Y = С + I) is the same thing as the saving-investment approach. Investment being autonomous of income means that it does not change with the level of income. Multiplier is one of the most important concepts developed by J.M. 18.1(b), and investment will increase from OI2 to OI0. It follows from above that the Keynesian assumptions for the working of multiplier in real terms, namely: (a) The supply of output of goods is elastic due to the existence of large excess capacity. Anything which increases a firm’s profit prospects by increasing R will increase its level of investment. According to Keynesian theory, there are two approaches, they are Aggregate Demand - Aggregate Supply Approach and Saving Investment Approach; Let us see few illustrations which explain the two sector models. 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. Khatkhate wrote, “In conclusion we may state that the multiplier can operate in an under developed economy when it is associated with a carefully designed pattern of investment. If ∆Y stands for increase in income, ∆l stands for increase in investment and MPC for marginal propensity to consume, we can write the equation (i) above as follows: It is clear from above that the size of multiplier depends upon the marginal propensity to consume of the community. The marginal efficiency of capital decreases as the amount of investment increases (as shown in Fig. presentation on keynesian theory 1. guided by: mrs. rajni mam presented by: neha sharma 30/15 2. i. classical theory ii. But the reverse process will not stop here. 100 crores, the national income increases by Rs. With marginal propensity to save (MPS) being equal to 0.5 or 1/52, the value of multiplier would be 1/MPS= 1-1/2= 2. In other words, the increases in saving by Rs. 50 crores has led to the fall in income by Rs. (c) There exist involuntarily unemployed workers searching for work and. In Keynesian study the symmetry level of employment and earnings is ascertained at the point of equality between saving and 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. The drastic drop in private invest­ment appears to be the basic reason for the huge fall in aggregate demand or spending. The theory that the multiplier works in a backward economy only with reference to the money income is based on static assumptions and is, therefore, not correct”. But it is not necessary that all the money raised through taxation is spent by the Government as it happens when Government makes a surplus budget. The multiplier tells us how much increase in income occurs when autonomous investment increases by Rs. Hence it was difficult to increase agricultural production in response to the increase in demand through the multiplier effect of increase in investment. An important result of the success of the Keynesian model was that fiscal policy as an instrument for controlling business cycles came into prominence. The MEC is the rate of discount which equates the present value of a series of cash flows obtainable from an income-earning asset like a machine over its entire economic life to the cost of the machine. The public investment in public works such as road building, construction of hospitals, schools, irrigation facilities will raise aggregate demand by a multiple amount. In fact, the value of multiplier is the reciprocal of marginal propensity to save (∆Y/∆I = 1/MPS or 1/s) When marginal propensity to consume is 0.8, marginal propensity to save will be 1 – 0.8 = 0.2. An interesting paradox arises when all people in a society try to save more but in fact they are unable to do so. For example, during the first four years (1929-33) of depression in the USA the unemployment which was only 3.2 per cent in 1929 soared to 25 per cent in 1933, that is, one out of four in the labour force in the United States became unemployed. When investment in an economy rises, it has a multiple and cumulative effect on national income, output and employment. According to the Keynesian theory, the saying “penny saved is penny earned” is quite inappropriate for the economy as a whole when it is working at underemployment equilibrium, that is, when there prevails recession or depression. So even small changes in interest rates will have significant impact upon investment (the marginal efficiency of capital/investment curve being very shallow). The Keynesian Explanation of Great Depression: The Impact of Multiplier: Limitations of Working of Keynesian Multiplier in the Developing Countries. This had a great success in removing unemployment and depression and therefore, Keynesian theory of multiplier was vindicated and as a result people’s belief in it increased. 10.3 and correspondingly aggregate demand curve in the lower panel (b) shifts to the right to AD1 and brings about increase in GNP level from Y0 to Y2with the given fixed price level Pr In the second stage due to the upward sloping short-run aggregate supply curve SAS, the rightward shift in the aggregate demand curve causes price level to rise from P0 to Pt and causes decrease in GNP from Y2to Y1. Influential economic factors include the overall price level, the interest rate, and the level of employment (or equivalently, of income/output measured in real terms). 200 crores. 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. YFY1 is twice that of HT. The multiplier can be explained with the help of savings investment diagram, as has been shown in Fig. 100 crores will spend a good part of them on consumer goods. As a result, economy experiences rapid upward movement. This aspect was neglected by economists for over 100 years. This reduces the size of the multiplier. In that case as a result of some initial increase in investment, income would go on rising indefinitely. The Keynesian theory of interest is an improvement over the classical theory in that the former considers interest as a monetary phenomenon as a link between the present and the future while the classical theory ignores this dynamic role of money as a store of value and wealth and conceives of interest as a non-monetary phenomenon. Therefore, when income and demand increase as a result of increase in investment, it generally raises the prices of these goods rather than their output and therefore weakens the working of the multiplier in real terms. So long as the MEC is greater than r, new investment in plant, equipment and machinery will take place. 10.2. In our above analysis of the working of the multiplier process we have taken the example of a closed economy, that is, an economy with no foreign trade. As a result, consumption expenditure declines due to this wealth effect. Most of the modern economists agree with the concept of Keynes. For this Government will pay wages to the labourers engaged, prices for the materials to the suppliers and remunerations to other factors who make contribution to the work of road-building. 300 crores) to Y2 (Rs. 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. 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. 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. Similarly, Dr. D.R. With this increase in investment, the investment curve shifts to the new dotted position TF. If the people hold apart of their increment in income as idle cash balances and do not use it for consumption, they also constitute leakage in the multiplier process. (b) What will be the increase in national income if investment increases by Rs. This investment level OI has been determined by the marginal efficiency of capital and the rate of interest. Investment will be profitable up to the point where the marginal efficiency of capital is equal to the cost of capital. Privacy Policy3. In the real world, all income received by the people as a result of some increase in investment is not consumed. A Keynesian believes […] The multiple increase in income and demand will also encourage the increase in private investment. He also maintained that deliberate government action could foster full employment. The first three describe how the economy works. This implies a horizontal short-run supply curve. But when the rate of interest drops to R1, investment hikes to OI2. Here Rn is the expected cash flow from the machine in the last year which also includes the scrap value of the machine. Keynesian economic theory says that spending by consumers and the government, investment, and exports will increase the level of output. (ii) An increase in the growth rate of the economy: Keynes assumed that all investment is autonomous and is thus independent of national or per capita income. The concept of multiplier was first of all developed by F.A. That is, increment in income takes place instantaneously as a result of increment in investment. The argument for non-operation of multiplier in underdeveloped countries was also partly based on the inelastic nature of supply of agricultural output especially food grains as it was pointed out that a large part of monetary demand or money incomes generated by investment would be spent on food grains. 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. The Keynesian perspective focuses on aggregate demand. 50 crores at every level of income the saving function (SS) shifts upward. 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. Share Your PDF File When output of consumer goods cannot be easily increased, a part of the increases in the money income and aggregate demand raises prices of the goods rather than their output. 300 crores, multiplier is equal to 3. This depends on the immediate profits (cash flows) expected from operating the project and the rate at which these are expected to decline through reduction in the price of output, or increases in the real wages or cost of raw materials and fuel. By contrast the monetarists argue that investment is very interest rate-sensitive. Thus commenting on Dr. Rao’s article, Dr. K.N. Therefore, real income or output increases by the same amount as the increment in money incomes, since the prices of goods have been assumed to be constant. Share Your PPT File, The Neo-classical Theory of Investment (With Diagram). Thus, with increase in investment by Rs. 10.4. Besides, at times there is a lot of excess or unutilized capacity in several industries in India due to the deficiency of aggregate demand. Empirical evidence tends to support the Keynesian view that interest rates have only a limited effect on investment. 10.2 that saving and investment curves intersect at point E, that is, planned saving and planned investment are in equilibrium at the level of income OY1Thus, with the given saving and investment curves level of income equal to OY1 is determined. Keynesian Theory of Interest. In our above analysis of the multiplier process we have taken a closed economy, that is, we have not taken into account imports and exports. classical theory vs. keynesian iii. But besides saving, there are other leakages in the process of income generation which reduce the size of the multiplier. 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. Thus, this will further increase incomes of some other people equal to Rs. Keynes treated investment as autonomous of income and we will here follow him. Secondly, we have assumed that there is a net increase in investment in a period and no further indirect effects on investment in that period occur or if they occur they have been taken into account so that there is a given net increase in investment. No doubt, if the Government expenditure increases by an amount equal to the taxation, it would not have any adverse effect on the increases in income and investment and in this way there would be no leakage in the multiplier process. One limiting case occurs when the marginal propensity to consume is equal to one, that is, when the whole of the increment in income is consumed and nothing is saved. Had there been no saving and as a result marginal propensity to consume were equal to 1, the multiplier would have been equal to infinity. As we know that saving is equal to income minus consumption, one minus marginal propensity to consume will be equal to marginal propensity to save, that is, 1 – MPC = MPS. The people who receive Rs. He in his book 'General Theory of Employment, Interest and Money' out-rightly rejected the Say's Law of Market that supply creates its own demand. Therefore, multiplier is equal to 1/ 1- MPC =1/MPC. Further, according to classical economists, savings determine investment which plays a crucial role in accelerating the rate of economic growth. Dass Gupta, expressed during the early fifties regarding non-operation of the Keynesian multiplier in the under developed countries. Share Your Word File Thus, multiplier = 1/1 – MPC = 1/1 – 3/4 = 4. 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. Therefore, in the developed capitalist economies ridden with depression increase in investment leading to successive rounds of consumption expenditure raises aggregate demand. 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. We explain below the various leakages that occur in the income stream and reduce the size of multiplier in the real world. But the situation in the present-day developing countries has substantially changed in the last 60 years. 80 crores will also in turn spend these incomes, depending upon their marginal propensity to consume. 50 crores which would cause an autonomous downward shift in the consumption function. A favourable technological change (not an adverse technology shock) will shift the MEC schedule to the right and will increase the volume of investment even if the rate of interest remains constant. Keynes gives all attention to the ADF. The following factors affect a firm’s investment decisions: If managers are more optimist about the future, they will place more orders for machines. The MEC is calculated by using the following formula: where C0 is the purchase price of the machine in the base year, R1, R2, etc. Introduction to Keynesian theory and Keynesian Economic Policies Engelbert Stockhammer Kingston University . Multiplier effect of new investment can be further increased, if investment package is quite diversified covering a large number of industries (including agriculture) so that monetary demand and income generated by any one industry can be adequately met by increase in output capacity in other industries. In Fig. 10.3. 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. Before publishing your Articles on this site, please read the following pages: 1. Kahn developed the concept of multiplier with reference to the increase in employment, direct as well as indirect, as a result of initial increase in investment and employment. Macroeconomics is the study of the factors applying to an economy as a whole. The MEI is that rate of discount that would make the present value of the capital assets' expected series of an- nuities just equal to its supply price. The Keynesian perspective focuses on aggregate demand. 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. Changes in interest rates should have an effect on the level of planned investment undertaken… 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. If as a result of investment of Rs. Keynesian theory was introduced with the book "The General Theory of Employment, Interest, and Money" 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. Of course, when incomes received by the moneylenders, banks or institutions are again lent back to the people, they come back to the income stream and enhance the size of multiplier. It will be seen from Figure 10.6 that the decline in national income YFY1 is not equal to the fall in investment by HT by out by a multiple of it. This induces them to spend less. The MEC is the rate of return at which a project is expected to break­even. The multiplier can be illustrated through savings investment diagram also. It is assumed that to begin with, say in 1929, the aggregate demand curve C + I2 intersects 45° line at point H and determines equilibrium level of income at full-employment or potential output level OY1. 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. 100 crores. 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. Keynesian Economics is an economic theory of total spending in the economy and its effects on output and inflation developed by John Maynard Keynes. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. Prior to Keynes (1936), the NTI was based on the assumption that the future is certain, in which case that interest rate is the risk-free rate. Therefore, the money used for payment of taxes does not appear in the successive rounds of consumption expenditure in the multiplier process, and the multiplier is reduced to that extent. Therefore, the value of the multiplier is greater than one but less than infinity. Consider Fig. The above various leakages reduce the multiplier effect of the investment undertaken. 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. However, as studied above, short-run aggregate supply curve slopes upward as the firms are willing to supply additional output in the short run only at a higher price level. The below mentioned article provides a complete guide to Keynes’ theory of investment multiplier. This new aggregate demand curve C + I intersects income line at point F so that the equilibrium level of income increases to OF As a result of net increase in investment equal to EH. Thus the attempt by all people to save more has led to the decline in the equilibrium level of income to Y2 or Rs. Of course, we have assumed, that there exists excess productive capacity in the consumer goods industries so that when the demand for consumer goods increases, their production can be easily increased to meet this demand. This downward shift in the consumption function brings about an upward shift by Rs. 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. The concept of multiplier was first of all developed by F.A. This will enable them to make more profit by venturing out in those areas where demand for consumer goods is picking up. In the given consumption function (C = 80 + 0.75 F) marginal propensity to consume is equal to 0.75 or 3/4. But it was thought that the increase in income will be limited to the amount of investment undertaken in these public works. 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. If as a result of the investment of Rs. We now turn to the second of the four elements encompassed by Keynes’s treatment of saving and investment, namely, the nature of saving and its relationship to investment. The Neoclassical and a Post Keynesian theory of investment Under the neoclassical theory of investment (NTI), the marginal rate of return on investment is equated with an interest rate. This is because initial investments are concentrated on the ‘best’ opportunities and yield high rates of return; later investments are less productive and secure progressively lower returns. According to Keynesian theory-factors other than the interest rate affect savings and investment - if investors are pessimistic about future returns, they may not invest more as interest rates fall. 1. It makes the two sides of the above equation equal. Suppose Government undertakes investment expenditure equal to Rs. The amount of investment undertaken depends not only on expected returns but also on the cost of capital, that is, the interest rate. the income has increased by Y2Y2It is seen from the figure that F, Y2 is greater than EH. 1, that is, investment multiplier ∆Y/∆I is and its value is equal to 1/1-b where b stands for marginal propensity to consume (MPC). Suppose further that marginal propensity to import is 1/4 , the size of the multiplier without imports will be equal 4 to equal to 4 but the size of the multiplier with the marginal propensity to import equal to 1/4 and the marginal propensity to consume equal to 3/4 will be smaller. The increments in income which the people receive as a result of increase in investment are also in part used for payment of taxes. It is worth noting that multiplier not only works in money terms but also in real terms. As a result, the theory supports the expansionary fiscal policy. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. However, the neo-classical economists such as Dale Jorgenson and his co-workers have abandoned the classical and the Keynesian theories of investment on the ground that both are unrealistic. F.A. Multiplier in an Open Economy = 1/ 1 -(MPC-MPI) = 1/1 – MPC + MPI. This looks rather simple but during the early 1930s it was not understood at all. It is to this theory to which we turn now. In this way the paradox of thrift has been averted. It is easy to explain this. The concept of the change in aggregate demand was used to develop the Keynesian multiplier. are the expected cash flows from the machine in the first, second and subsequent years and e is the MEC which acts as the balancing factor. Therefore, multiplier here is equal to 5. If expectations change and investors expect to receive better returns from each investment — because, for example, of technological progress — then at any given rate of interest such as 20%) more investment will be undertaken than before; that is, the marginal efficiency of capital schedule will shift to the right, as shown in Fig. This would have caused increment in income in foreign countries rather than within the country. The first leakage in the multiplier process occurs in the form of payment of debts by the people, especially by businessmen. Thus, we see that the income will not increase by only Rs. Therefore, the multiplier is reduced to the extent of price inflation. Thus, according to them, in a free-market and private enterprise economy without Government intervention paradox of thrift cannot be averted. The multiplier is the reciprocal of one minus marginal propensity to consume. 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. Keynesian explanation of paradox of thrift has been shown in Fig. 100 crores is made, then the income will not rise by Rs. 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. But, as has been explained by Keynes, the decrease in aggregate expenditure was not merely equal to $ 47.5 billion, but by a multiple amount due to the operation of the multiplier in the reverse. It is because of this that the role of the Government has greatly increased for overcoming recession in the capitalist countries. The MEC is the rate of return (profits) on an extra rupee worth of investment. This is because monetary demand or expenditure generated by investment in any one industry would be easily met by the increase in production capacity in a variety of industries. Keynes argued that investment, which responds to variations in the interest rate and to expectations about the future, is the dynamic factor determining the level of economic activity. Illustration 12 Harrod-Domar in their famous dynamic growth models emphasized that investment not only creates demand but also new productive capacity. In our above analysis of multiplier with aggregate demand curve, it is assumed that price level remains constant and the firms are willing to supply more output at a given price. This is in accordance with the value of multiplier being equal to around 2. A simple method of calculating e for an infinitely durable capital good is available. Before publishing your Articles on this site, please read the following pages: 1. Thus, Keynes recommended Government investment in public works to solve the problem of depression and unemployment. Multiplier is here equal to. The size of multiple is determined by the value of marginal propensity to consume. Modern Neo-Keynesian and Post Keynesian theorists have attempted to insert capital stocks into Keynesian theory in order to obtain a "more complete" macroeconomic theory, but have generally adhered to Keynes's strategy of placing the investment decision as the centrepiece and subordinating capital stock considerations to it. 10.5 the new equilibrium level of income may not fall and therefore the paradox of thrift is averted. Then out of Rs. C + I represents aggregate demand curve. This new aggregate demand curve C + I1 intersects the 45° line at point E and accordingly determines equilibrium level of income OY1 which is much lower than full-employment level OYF and thus represents a state of depression with a large unemployment of workers. This explains the paradoxical feature of an economy gripped by recession. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. Kahn in the early 1930s. 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. However, this is unlikely to occur since marginal propensity to consume in the real world is less than one. Rao, Dr. A.K. Describe the Keynesian viewpoints on the determinants of consumption expenditure and investment expenditure; Describe the Keynesian perspective on factors that determine government spending and net exports; Aggregate Demand in Keynesian Analysis. The theory of multiplier occupies an important place in the modern theory of income and employment. As soon as MEC is equated to r, no new investment will be made in any income-earning asset. 50 crores), that is, by the extent of reduction in consumption due to more saving but by a multiple of it. The Keynesian theory of employment and income is also explained in terms of the equality of aggregate supply (C+S) and aggregate demand (C+I). The multiplier is illustrated in Fig. Controlling the magnitude of an economic boom is important since too much investment in the public and private sectors could lead to a reduction in the money supply and a severe recession as a result. According to a proverb, “a penny saved is a penny earned”. TOS4. R.V. 25 crores depends on the size of multiplier. That is, in this case, the increment in income will be equal to the original increase in investment and not a multiple of it. The total cost will amount to Rs. It will be readily apparent from Fig. Another important assumption in the theory of multiplier is that excess capacity exists in the consumer goods industries so that when the demand for them increases, more amounts of consumer goods can be produced to meet this demand. 18.1 that there is a link between the monetary side of the economy and the real economy a fall in interest rates will stimulate more investment, which, in its turn, will result in a higher level of national income. The effect of increase in consumption demand on expansion in investment is generally referred to as accelerator. 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. Keynes's income‐expenditure model. Keynesian Studies. 100 crores. Imports are important leakage from the multiplier process and we have ignored them in our above analysis for the purpose of simplicity. Content Guidelines 2. Therefore, the increments in demand raise the prices of goods to a greater extent than the increase in their output. 100 crores they will spend Rs. Given the demand function for money (Md), the decline in the real money supply will cause rate of interest to rise. But other factors also enter into the model - not least the expected profitability of an investment project. The methodological incompatibility of the New Keynesian theory of investment instability described by Fazzari and Variato and Keynes’s theory of investment instability outlined here is striking. To get rid of depression and remove unemployment, Government investment in public works was recommended even before Keynes. The multiplier effect in case of upward sloping curve is shown in Fig. Indeed, the combined working of multiplier and acceleration, which is called super-multiplier, leading to manifold increase in output can take place in the growth process in the developing countries like India. 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 1929-33. Now, the rise in interest will induce private investment expenditure to decline. “In such circumstances, the Government would need to employ only one road builder to raise income indefinitely, causing first full employment and then a limitless spiral of inflation.”. As mentioned above, the size or value of multiplier can be calculated using either the value of marginal propensity to consume (MPC) or the value of marginal property to save (MPS or s). This is because we have here assumed that propensity to save is equal to 1/2 (Or marginal propensity to consume is equal to 1/2) Therefore, the slope of the saving curve has been taken to be equal to 1/2 or 0.5 Thus in this case multiplier is equal to 2. 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. Thus, as a result of the sharp drop in private investment and resultant fall in induced consumption due to working of multiplier caused much bigger decrease ($ 93 billion) in the level of aggregate effective demand, income and output. In this figure C represents marginal propensity to consume. Let us make an in-depth study of the Keynesian Theory of Investment. The Keynesian multiplier effect is very small in developing countries like India since there is not much excess capacity in consumer goods industries. 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. As we have seen, people keep part of their income for satisfying their precautionary and speculative motives, money kept for such purposes is not consumed and therefore does not appear in the successive rounds of consumption expenditure and therefore reduces the increments in total income and output. If there is no excess capacity in consumer goods industries, the increase in demand as a result of some original increase in investment will bring about rise in prices rather than increases in real income, output and employment. If all possible projects in an economy are arranged in descending order of their MEC, investors will accept those with MEC higher than r and reject those whose MEC is lower than r. The MEC is not the same as the marginal product of capital which is concerned only with the immediate effect of additional capital on possible output and not with how long the resulting profits can be expected to persist. The wider the range to industries over which initial investment is undertaken, the greater will be the multiplier effect. However, we shall discuss later that this old view about the working of Keynes’ multiplier is not fully correct. Suppose in a country investment increases by Rs. Therefore k = ∆Y/∆I where k stands for multiplier. Keynes to explain the determination of income and employment in an economy. Note that the value of multiplier ∆Y/∆I will remain constant as long as marginal propensity to consume remains the same. This new saving function curve S’S’ cuts the planned investment curve II at point E2 according to which new equilibrium level of income falls to Y2 or Rs. On measuring these increments in income and investment it will be found that the increment in income Y1 Y2 is two times the increment in investment II. Now suppose that expecting hard times ahead all people try to save more by the amount of Rs. 10.4, where 55 is the saving curve with a slope equal to 0.5, and II is the planned investment curve. 100 crores, which was initially invested in the construction of roads, but by many times more. 100 crores (50 x 2) from its initial equilibrium level of income Y1 of Rs. 200 crores at which, with marginal propensity to consume remaining unchanged at 0.5 or ½, saving of the society will fall to the initial level of Y1E or Rs. This new investment curve II intersects the saving curve at point F and a new equilibrium is reached at the level of income OY2 A glance at Fig. According to Keynes investment decisions are taken by comparing the marginal efficiency of capital (MEC) or the yield with the real rate of interest (r). where a is a constant term, b is marginal propensity to consume which is also assumed to remain constant. 10.1. 10.3, the aggregate demand curve AD1 intersects the short-run aggregate supply curve SAS at point R’ and as a result price level rises to P1. Now, with this rise in price level to P1, aggregate expenditure curve in the upper panel (a) will not remain unaffected but will shift downward. Once we relax these two restrictive assumptions, the essential content of the Keynesian multiplier, that is, increase of investment results in an increase in output which is much in excess of the original outlay on investment, holds true in case of the developing as much as in the developed economies”. In our above analysis, saving is a leakage in the multiplier process. In this case, the value of the multiplier will be equal to one. A fall in the interest rate to 10% increases the amount of profitable investment 0I1. The classical economists attributed this unemployment and depression to the higher wage rates maintained by the trade unions and the Government. 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. Suppose you have an opportunity to purchase an asset which costs Rs. So industries producing such goods will be stimulated and the managers of such industries will place more orders for purchase of machines. 10.3, when price level effect is taken into account, the increase in investment expenditure has still a multiplier effect on real GDP but this effect is smaller than it would be if price level remained fixed.

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