Multiplier Effect
Welcome friends, to the lecture-12 of our course an International Business. So, let mestart the lecture today with the current situation that is prevailing in India.(Refer Slide Time: 00:40)So, this condition that we are going through in India is, if the Indian economy is in itslightly tough condition, right. So, we all are aware of it that the growth is not happeningas desired and things have slowed down, right.So, what it says is the gross domestic product grew 5 percent in the first quarter offinancial year 20 the data, as per the data released by the government. Marking theslowest growth since the fourth quarter of financial year 13, right. So, there is a longtime. So, the GDP growth was 8 percent in the year earlier quarter and 5.8 percent in thepreceding one.So, this 5 percent growth is somewhere a scary figure, right. So, we are scared that theeconomy is not going the way it should be. The consumption, which is a bedrock or themajor factor behind the growth of the economy or you know, has collapsed to an 18-quarter low of 3.1 percent from 10.6 percent in the March quarter, pointing to a fragilesentiment, that means, the consumers are not very happy, they are scared.The slowdown in investment and consumer demand derailed the manufacturing, whichgrew just 0.6 percent, right. A meagre 2 percent rise in farm sector added to the demandslowdown.(Refer Slide Time: 02:13)So, if you can see, this numbers are very dangerous, right. Looking at, this is what I havebrought from the economic times. So, you can look at it, that this 5 percent is the concernthat we have, ok.And if you look at the, you know the last years average complete full years growth GDPwas 6.8 percent, but we are worried, if this is the way we are start we have started with 5percent, then we might end up very low and then it could be disastrous, ok. The 8 percentnominal GDP is a growth is lowest, since financial year 2002-2003; that means, around16- 17 years back, right; that means, we are really having a slump, ok.3.1 percent private consumption rise is the worst in the 18 quarters. So, I am not trying todiscourage or create a negative impact, but this is the truth. Sector wise growth also ifyou see, for example, look at manufacturing; it is 0.6 percent only, which is almostnegligible. In comparison it was 12.1 percent during the same time in the financial year19.If you look at agriculture, which is one of the largest employers, it is 2. 2 percent growth,right; again decimal figure. Whereas, the government has been thinking of doubling thefarmers income, right and creating more employment through you know, throughagriculture forestry and fishing.But, on the other side we are finding a growth of only 2 percent, which is quitedangerous. Other things also if you see mining, querying, only 2.7 percent growth andlast year it was 0.4. So, although it seems a positive slight positive, but that it is notactually positive, it is only 2.7 percent growth over this.So, overall; that means, if you see, none of the industries have are doing well, right. So,only thing we can be happy in maybe a few, for example, which is substantially still, ok;is utilities you know, and defense where the government is spending largely and they aredoing well, right. What lies ahead; what are the worry lines and what are the you know;what lies ahead? Further rate cuts, sentiments boosters needed, right.The government had to enter, has to interfere. The finance minister’s stimulus packagemay propel the demand, but before that we should look at the you know, worry lines.Sharp slowdown in the private consumption. There was article where it said parley isgoing to cut down 10,000 jobs, because even people are not ready to pay, buy a pack ofbiscuits worth 10, 5 rupees. So, that shows how consumer psychology is down.Low domestic growth global demand, low domestic and global demand. Negligiblegrowth in manufacturing, right. So, the gross value added is negligible. Governmentspending is the key driver, and we hope the government does something which willrebound; which will help the industry to bounce back, ok.(Refer Slide Time: 05:32)So, what are the measures? As one of the measures the finance minister has been taking;now, the finance minister has and the think tank has been thinking’s, you know seriouslyon this and they have you know started some measures.For example, a 10,000 crore window, which is actually 10,000 from the government +10,000 from the private makes it 20,000 actually, = 20,000, right; to fund the incompletehousing projects, right. Because the real estate sector has been in you know, in a verybad condition for last many years now.The RBI has cut the interest rates four times, right; since January to 5.4 percent by toAugust, right; to help the to help boost the loan growth, right. So that people take moreloans at a lower interest rate and thus, maybe production will increase.The government has announced a slew of measures in 3 dosages which include a specialwindow for real estate, export incentives, bank consolidation, and you must have heardof the major banks being, you know merged together. And sops for micro small andmedium enterprises and the automobile sector which is a key sector, right.So, taking the if the right measures are taken then I am sure the economy will do well,but if something is not done correctly, if something happens, then we can see difficulttime, right. So, you can see, the always the stock market is a mirror to which reflects thesentiments of the market and you can see the stock market bleeding very badly, at themoment.So, in such a time as it says here, if you can see, further rate sentiment boosters areneeded.(Refer Slide Time: 07:22)So, we will talk about a topic today which is very important, which is called theMultiplier effect. So, what is this multiplier effect? Let us start with it. Investmentmultiplier is the ratio of change in equilibrium income and change in investment thatcauses it, right.So, what change happens when an investment is done? So, what is the change in income,when investment is done by the government or maybe some private investment comesin?Samuelson the Nobel laureate says, multiplier is the number by which the change ininvestment must be multiplied. This is a number which should be multiplied with thechange in the investment. So, what is the change in investment in the last year to thisyear? In order to determine the resulting changes in total income; that means, it saysincome changes income changes when there is a change in the investment.So, this investment change, when multiplied with some number, let us say with somenumber, magic number, then this number will help you to find out the change in the totalincome, right. This concept of multiplier, so you can understand, what is a multiplier?Multiplier is to multiply something, so it multiplies.So, when you, when the government invests in some sector or in the totality in thegrowth of the nation, so, or anybody for example, let us say. Then what happens is,because of the investment, the wages, the salaries, the income of people will grow and asa result of it, this consumption will grow and as a result of the increase in consumptionproduction will grow, right.So, automatically there will be a demand. So, this demand this change in effect, due tothe change in income as a result of the investment of the government or anybody iscalled the multiplier effect. The concept of multiplier was first said by the famouseconomist R. F. Kahn, in an article titled “The Relation of Home Investment toUnemployment”. So, in 1931, where he talked about for the first time the, employmentmultiplier, right.John Maynard Keynes was the one who talked about the, where he introduced theconcept, where he talked about the governments intervention to boost up the economy,and he says, he emphasized on the significance and utility of public investment, right;government which refers to government expenditure on public works and public welfareactivities.The purpose of this investment is not to on profit, right. As is the case with privateinvestment, it is called autonomous investment, because there is no private of a profitintention behind for the government, because it is independent of profit motive. But toincrease employment and stimulate the business during acute cases of depression. Theremay be depression there may not be a few anticipate, there is a depression going to comeor a recession going to come, the government should do this, right.So, what is it saying? So, multiplier is equal to change in income divided by the changein initial investment. So, multiplier M is equal to change in income delta I divided by thechange in the initial investment. So, let me say investment, right. So, income byinvestment. So; that means, what? The change in investment into the multiplier isnothing, but the change in income, ok.So, let us see, what is this marginal propensity to save? Let us define understand it. So, itrefers to the increase in the proportion of saving; which is saving is equal to saving isequal to income minus the consumption, right. So, refers to the increase in the saving,right; as a result of the increase in the level of income.So, when income grows when income is growing, what happens to the saving? So, issaving growing or consumption growing? What is happening? It can be defined as theratio of change in saving to change in income, right.So, what it says symbolically? MPS; marginal propensity to save is equal to the changein saving divided by the change in income. So, Y is the change in income, right andchange in saving.(Refer Slide Time: 15:13)Now; let us see, an income rises from rupees 50,000 to rupees 60,000. Saving increasesfrom rupees 10,000 to rupees 18,000. In this case, what is the MPS, find out? So, whatdid it says? Change in saving, if you look at it, change in saving by change in income.So, change in saving is how much? Here, change in saving is 8,000, right; change inincome is 10,000, right. So, what is the ratio? So, this is the 1, right.(Refer Slide Time: 15:47)Similarly, there are other questions you might answer. Assume that the consumptionspending is 16,000. For every rupees 200 increase in disposable income, saving goes upby rupees 20. Which of the following statements is true? Try to answer it, right.(Refer Slide Time: 16:01)Then we come to the marginal propensity to consume. MPC is the increase in consumerspending due to an increase in income. So, when income is growing either a person willtend to save it or he will tend to consume it.So, if he makes more consumption then what happens, right? This is expressed as delta Cby delta Y; that means, change in consumption divided by the change in income, right.MPC is the reverse or the inverse of the marginal propensity to save, right. So, it is eitherif you save you cannot consume, if you consume you cannot save, as good as that. Forexample, if a person earns 1,000 extra and spends 550. So, the marginal propensity toconsume will be 550 divided by 1,000; which is 0.55, ok.This ranges between 0 to 1, ok, because it cannot go beyond the income. You will, it isunderstood, this is an assumption of the you know, assumption that you can always liewithin the up to the income you can reach; so, maximum, right. So, the numerator anddenominator will be only same. It cannot, the numerator cannot be more than thedenominator, ok.If a person’s entire increase in income is consumed, then the change in consumption willbe equal to the income, same income making MPC is equal to 1. So, you can understand;change in consumption, you saying if everything is consumed; that means, whateverincome you had you consumed everything, so income and consumption is same. So, thevalue becomes 1, right.If the entire income is saved and nothing is consumed then it is 0. So, MPC becomes 0,right. If you save, everything you do not consume anything then it is a again ahypothetical situation which is 0, right. So, 0 and 1 actually are hypothetical situations.(Refer Slide Time: 17:55)Mr. Rajesh receives 10,000 bonus apart from his annual salary. Now, he has an extraincome of 10,000 to spend, that he did not before. You get bonus during Diwali there areincentives.Suppose; example, right suppose that the individual decides to spend 8,500 of this10,000 on a vacation and remaining amount will be saved for future purposes. Find theMarginal propensity to consume and the marginal propensity to save. What will be theMPC; if the individual saves the entire 10,000; individual spends the entire 10,000, right.(Refer Slide Time: 18:33)So, look at this. So, what it saying? Marginal propensity is change in consumption bychange in income. Saving is; change in saving by change in income. So, propensity toconsume, marginal propensity to consume MPS will be 8,500, right; look at it. So, 8,500he is spending on 10,000. So, which is equal to 0.85.What is the saving? Obviously, 15,00 the remaining; so, 0.15. If the individual saves theentire 10,000 the MPC will be? He is not consuming anything, so it is 0 by 10,000. If theindividual spends the entire 10,000 then MPC will be 1. So, this is the condition, right.(Refer Slide Time: 19:13)So; this is a case, you can complete this table. This data, you can see. So, what ishappening? So, this is income this is, consumption expenditure, right. So, how much isthe saving this time? 100.So, first year we are not giving any saving and consumption. We do not have the data,right. From next year onwards, you can count it; you can do that. So, try to fill up thisfigure and find out the answer, right, ok.(Refer Slide Time: 19:40)There is one more term, the marginal propensity to import. What it is saying? Themarginal propensity to import is the amount of import increase or decrease with eachunit rise or fall in the disposable income.What it is saying? The amount of import increases or decreases import means; to get theraw materials from outside with each unit or you know, rise or fall in the disposableincome, that extra income that I have, right.What is disposable income is a net income available to invest save or spend after mytaxes income taxes calculated by subtracting income taxes from income, it is the changein imports induced by change in income. So, delta I imports by delta income, right, ok.(Refer Slide Time: 20:29)There are two types of multipliers; as I said, one was given by Kahn, which was said asthe employment multiplier; the other was given by Keynes, John Maynard Keynes, JohnMaynard Keynes and he said foreign trade multiplier, right.So, he did not exactly say about it, but then what is this? Let us see, the employmentmultiplier is the ratio of increase in total employment. What it is saying? The ratio ofincrease in total employment. So, change in employment, right; to the increase inprimary or original employment to the total employment, right. So, change inemployment to the over total employment.Similarly, there is one more term called the foreign trade multiplier. Now, what is thisforeign trade multiplier? The ratio of change in total income to the change in the exportincome, right. So, total income change in the total income change, only the changedivided by the change in the export income is called the foreign trade multiplier. So, letus see.(Refer Slide Time: 21:36)First, let us understand some of the characteristics of the multiplier. So, what it says? It isdependent on the aggregate demand. Now, aggregate demand is the total demand or therequirement or the demand for services or products goods is called the aggregatedemand.So, that is the investment and consumption, cause the multiplier effect. Economistsgenerally associate multiplier with change in investment. However, change inconsumption or government expenditure or exports can have the similar effect.Another multiplier effect is that it works both forward and backwards. Suppose, there isa cut in the spending, so there could be a backward effect, ok. There is an inverserelationship between marginal propensity to save and the size of the multiplier, right.Size of the multiplier depends upon the size sorry size of marginal propensity toconsume, right. Higher the consumption, greater will be the size of the multiplier, ok.The size of the multiplier is reduced proportionate to the leakages in the current incomeflow, right. So, what are the leakages? What are the you know, points where there areleakages, right? That also has an effect on the size of the multiplier.Multiplier effect can operate continuously only if there are continuous and autonomouschanges in expenditure in the economy. So, there has to be, it cannot be a static model.There are two models static and dynamic. So, earlier. In fact, the criticism for Keynes isthat, Keynes had given a static model, but today’s economists are talking about that themultiplier effect is built on a dynamic model. It is constantly changing. You cannotpredict anything you know, the on linearly, right; so they are saying it is a dynamiceffect.What are the importance? First of all let us talk about the importance of the multiplier.(Refer Slide Time: 23:45)The concept of multiplier tells us, that income propagation is a, propagation means;spread, is a natural process, right. It tells that increase in employment income and outputis due to the increase in investment, ok.Importance of investment second; it is the initial increase in the investment that results inmultiple increase in income. As I said; right, the workers will get more money. If theyget more money they will spend more, right. If they spend more there will be moreproduction, right. As a matter of fact, investment is a dynamic element on which changesin employment depend.Trade cycles; these are those cycles which tell business fluctuations take place over aperiod of long run. Trade cycles do not happen in very short period of time, they taketime, because there are lots of elements involved. So, it has it takes it is own time, right.So, the market tends to resist any change. So, but when it changes. So, it takes sufficienttime to make those visible changes.Sometimes there is a boom and another time there is a depression in the business. So,multiplier helps in understanding these trade cycles, right. Full employment;multiplayer’s concept of is of great importance while formulating policy regarding fullemployment. It shows that to attain full employment situation, net investment should beincreased, and thus, you can generate investment.You can see, some of the cases in even US when general motors Ford and Chrysler weregoing through a very bankruptcy condition, the government saved them from bankruptcyby injecting a lot of revenue into it, right.Another point is deficit financing; now, deficit financing sometimes; that means, what? Itas you can understand, this is a deficit financing by taking loans or something you are ona deficit, right. It helps in removing the bad effects. So, sometimes the criticism is there.The deficit financing is good or bad so, but it sometimes has a positive effect, because asa result of the deficient financing, investment increases. The increase in investmentcauses multiple increase in income in terms of the multiplier effect.So, what you have invested through deficit financing need not be equal to the growth.So, the growth is much more. So, on a net if you result you see finally, the growth ismore than the investment. So, finally, you are making some profits over the deficitfinancing.Equilibrium between saving and investment. Now, Keynes theory of Employment.Equilibrium is established when saving and investment are equal. Saving is equal to theinvestment. Equilibrium between saving and investment can be achieved through changein the level of income.If saving is low, it can be known from the concept of marginal propensity to save howmuch increase in income is needed to get the required increase in saving. So, it helps youto understand the equilibrium between saving and income and to, let us say to understandthe concept of marginal propensity to save you need to understand the increase inincome; how much increase in income is needed to get the required increase in saving.And to increase the level of income how much investment is needed, that can also bedetermined. Another importance of multiplier is; so, multiplier helps you to think [FL]how much of saving is required for every individual in a country, because every countryis different. How much of you know, consumption should be done? All these factors,right. How much income should be there, so that people can spend?Concept of multiplier testifies that if during depression, a little increase in publicinvestment is made, it will lead to multiple income increase and will help in controllingthe depression and unemployment. This is the basic you know, idea which is talked formultiplier effects.(Refer Slide Time: 27:44)Now, let us come, first two types of multiplier; the first one the employment multipliergiven by a Kahn, where R F Kahn says, that increase in investment will cause in increasein employment. So, if you invest the if you increase the investment employment willgrow, right. In those very industries, where in such investment has been made, but inother industries also.So, he says, not only in the directly in the industries where you have made theinvestment, but in the other industries also which are connected to it. For example, let ussay, if we invest in a production in a plant. So, if the plant grows; obviously, there wouldbe more of buyers, suppliers coming to that local place to buy those inventory. So, tostay they would need hotels, lodges, motels, so and maybe other items. So, automaticallythe secondary you know, businesses are also getting benefited, right.The service industries largely for example, so, it creates primary employment it createssecondary employment. So, how does it show? Now, K 1 which is the employmentmultiplier is equal to total employment, right; N 2 divided by the primary employment.So, what is the total employment? Divided by the primary employment, right. So, this iswhat it says is the, right; employment multiplier, ok.(Refer Slide Time: 29:11)Next, today maybe we will wind up here. Just I will explain, what is the Foreign TradeMultiplier. Here, it says that it is the amount by which the national income of a countrywill be raised, by a unit increase in domestic investment on exports, ok.Also known as the export multiplier. What it is saying? Foreign trade multiplier areknown as export multiplier is the amount by which the national income of a country willbe increased; raised when there is a increase, unit increase in the domestic investment.So, if I invest more, what is the change in the exports? How much increase in exports ishappening, right? This was given by Leighton, right, but large work has been done youknow by Keynes on this also.The foreign trade multipliers based on the following assumptions: so, these are some ofthe assumptions what it says, there is full employment. Which might not be correct.There is a direct link between domestic and foreign country in exporting and importinggoods. So, there is a direct link. So, there maybe a free movement.It is based on a fixed exchange rate system, but that is not true, right. Most of the timewe are on a flexible exchange rate system. There are no tariff barriers and exchangecontrols, which is highly untrue, right. So, there are some of other tariff barriers so;obviously, the motive behind the you know, beyond globalization is to remove the tariffbarriers, but still now it is not possible, it is not done, right.The government expenditure is constant; that is also not true, but still these are some ofthe assumptions that we have to take, right.(Refer Slide Time: 30:56)What I will do is, I will carry on for this multiplier effect in the next lecture, becausethere is a lot to be discussed. I hope, today you have understood what is this multipliereffect. In simple terms, sometimes there is a criticism for multiple effort also, because wesay it makes the same you know, statement again and again, there is a criticism for that,right.So basically, if I understand the more we invest in times of at least bad times or duringdepression or recessions.The investment will lead to higher spurt in growth in the industries, which will increasein the income of the people and thus, will incur effect the consumption of the people,consumption patterns and thus, the overall economy will grow, right. But if there is moreof saving and very less of consumption, it is also dangerous, right. If there is too much ofconsumption and you know, then we say then there is a chance that there will be highdemand for the products, right.So, this condition will differ from country to country as per the policies of thegovernment. Where in some countries the government gives lot of free education, freeinsurance, free policies for you know, and even you know there is a for unemployedpeople also there is some fixed income. So, such countries the kind of saving andconsumption differs to a country; for example, like India, Bangladesh, Pakistan aroundthese Asian countries, which in which there is a serious fear about the future.So, if we understand this, the government can even take action in putting in it isproductive money into such sectors; development of such sectors, so that people will nottry to save the income and they would like to consume, because if consumption happensthen only the demand will grow.So, if government can take up the security of the people, then automatically demand forthe products will rise and economy will do better; there is no doubt about it, right, but wewill talk about in the next class. I hope you enjoyed the lecture.Thank you very much.