Therefore, the increments in demand raise the prices of goods to a greater extent than the increase in their output. On measuring it will be found that Y1 Y2 is twice the length of EH. They argued this condition too was not fulfilled in the under developed countries where there existed disguised unemployment, especially in the agricultural sector. Keynes was, of 10.5, initially the saving curve (S1S1) and investment curve (II) intersect at point E1 and determine Y1 level of income. Now, if the people of the society expecting difficult times ahead,\ desire to save E1A more. Therefore, when there is injection of investment, and as a result through successive rounds of the operation of multiplier, aggregate demand for consumer goods increases, it results mainly in rise in money income brought about through rise in prices and not an increase in real national income. 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. In the early fifties an eminent Indian economist Dr. V.K. (1989) Keynes’s Theory of Investment and Saving. Keynes's income‐expenditure model. The below mentioned article provides a complete guide to Keynes’ theory of investment multiplier. Thus, Keynes recommended Government investment in public works to solve the problem of depression and unemployment. Given the marginal propensity to consume being equal to 0.5 or the producers/sellers of goods and services in turn would spend Rs.25 crores less when they find their income has fallen by Rs.50 crores. TOS4. TOS4. An interesting paradox arises when all people in a society try to save more but in fact they are unable to do so. Now suppose autonomous investment expenditure (which is independent of changes in price level) increases by AI. A Keynesian believes […] This will reduce the value of the multiplier. Illustration 12 To conclude, in the present economic situation of the Indian economy with a lot of excess production capacity in several consumer goods industries and a large potential for expanding agricultural production, increase in investment would produce a real multiplier effect on increasing real income and output without causing inflationary pressures in the economy. 10.3 aggregate expenditure curve shifts downward to AE1 (dotted) so that it determines GNP level Y1 at which aggregate expenditure curve AE1 intersects 45° line. The MEC is the rate of return (profits) on an extra rupee worth of investment. 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). 50 crores or E A in the saving function curve to S’S’. If ours were an open economy, then a part of the increment in consumption expenditure would have been made on imports of goods from abroad. 50 crores has led to the fall in income by Rs. He also maintained that deliberate government action could foster full employment. It will be seen from Fig. This reduces the size of the multiplier. If this happens, then in our saving-investment diagram the investment curve II would shift up to I’I’ and as will be seen from Fig. With the rise in price level, real value or purchasing power of wealth possessed by the people declines. 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. 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. So in the present state of the Indian economy and also of some other developing economies, it cannot be said that Keynesian multiplier is not applicable in real terms in them. The first leakage in the multiplier process occurs in the form of payment of debts by the people, especially by businessmen. Taxation is another important leakage in the multiplier process. Multiplier is here equal to. Further note that after taking into all leakages in the multiplier process it has been assumed that marginal propensity to consume is equal to 0.5 which yields the value of multiplier 1/1-MPC = 1/1-1/2 = 2, This is why fall in income by YFY1 is twice the decline in investment by HT. Here Rn is the expected cash flow from the machine in the last year which also includes the scrap value of the machine. It is important to observe that the saving which had risen to Y1A (Rs. Keynesian Theory of Income and Employment: Definition and Explanation: John Maynard Keynes was the main critic of the classical macro economics. 10.4. The first three describe how the economy works. 100 crores (Y2E2 = Y1E1) due to reduction in consumption expenditure inducing the working of multiplier in the reverse which causes a decline in the equilibrium level of income from Y1 (Rs. The public investment in public works such as road building, construction of hospitals, schools, irrigation facilities will raise aggregate demand by a multiple amount. Although the term has been used (and abused) to describe many things over the years, six principal tenets seem central to Keynesianism. ... which is the identity asserted by the economic theory of income equals expenditure models. 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. II is the investment curve showing the level of investment planned to be undertaken by the investors in the community. Thus the attempt by all people to save more has led to the decline in the equilibrium level of income to Y2 or Rs. 100 crores is made, then the income will not rise by Rs. Keynesian economics is a theory of total spending in the economy (called aggregate demand) and its effects on output and inflation. It may be pointed out that thanks to the spread of green revolution technology expansion in irrigation facilities in various states of India, food grain production can be adequately increased in response to rising demand for food grains. Since marginal propensity to consume is actually less than one, some saving does take place. 100 crores (200 x 0.5 = 100). By contrast the monetarists argue that investment is very interest rate-sensitive. But this is not all. For example, if marginal propensity to consume (b) is 0.8, investment multiplier is. 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. In that case as a result of some initial increase in investment, income would go on rising indefinitely. In our above explanation of multiplier, we have made many simplifying assumptions. In the Indian economy today there are a large number of involuntarily unemployed workers crying out for employment. 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. It goes to the credit of Keynes that with his multiplier theory he was able to resolve the paradox of thrift. But it was thought that the increase in income will be limited to the amount of investment undertaken in these public works. 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. C + I represents aggregate demand curve. 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. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. 100 crores because the multiplier is equal to 2. 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. 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. Kahn in the early 1930s. The marginal efficiency of capital decreases as the amount of investment increases (as shown in Fig. 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. the income has increased by Y2Y2It is seen from the figure that F, Y2 is greater than EH. 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. 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. 585 at the end of the first year and Rs. 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 Keynesian theory of employment and income is also explained in terms of the equality of aggregate supply (C+S) and aggregate demand (C+I). 100 crores. But those who receive these Rs. 10.6. which I think maps to the Post-Keynesian school where investment decisions by firms are validated by banks and other financial intermediaries who generate new credit to finance those investments. Therefore, imports constitute another important leakage in the multiplier process. A simple method of calculating e for an infinitely durable capital good is available. Multiplier is one of the most important concepts developed by J.M. 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. On the other hand, if the purchase price of capital (C0) increases, investment will fall. The above various leakages reduce the multiplier effect of the investment undertaken. 80 crores. ... Online Keynesian Theory of Income, Output and Employment Help: This fall in aggregate expenditure curve is due to the adverse effects on wealth or real balances, interest rate and net exports. 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. Therefore, multiplier in actual practice is less than infinity. Fig. 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. 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. Eco IAS 4,726 views Thus, the Keynesian theory of income determination provides a fairly accurate explanation of the first four years of the great depression. 300 crores) to Y2 (Rs. The essence of multiplier is that total increase in income, output or employment is manifold the original increase in investment. The concept of multiplier was first of all developed by F.A. The multiplier can be illustrated through savings investment diagram also. As will be seen from the lower panel (b) of Fig. As we shall see later, Keynes’ multiplier was evolved in the context of advanced capitalist economies which were in grip of depression and in times of depression and there did exist excess capacity in the consumer goods industries due to lack of aggregate demand. Thus the Keynesians economists claim that monetary policy will not be very effective in influencing the level of investment in the economy. 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. Keynes ignored the time-lag in the process of income generation and therefore his multiplier is also called instantaneous multiplier. Investment being autonomous of income means that it does not change with the level of income. Thus. According to Keynes investment decisions are taken by comparing the marginal efficiency of capital (MEC) or the yield with the real rate […] 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. Thus, according to them, in a free-market and private enterprise economy without Government intervention paradox of thrift cannot be averted. 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. However, if due to some bottlenecks output of goods cannot be increased in response to increasing demand, prices will rise and as a result the real multiplier effect will be small. Therefore, the value of the multiplier is greater than one but less than infinity. F.A. 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. In other words, the level of national income is fixed at the level where C + I curve intersects the 45° income curve. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. Share Your Word File How much increase will there take place in income? Keynes to explain the determination of income and employment in an economy. 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. 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. Keynesian theory was introduced with the book "The General Theory of Employment, Interest, and Money" 50 crores which would cause an autonomous downward shift in the consumption function. When incomes increase as a result of investment and these increments in income are spent on consumer goods, the output of consumer goods is increased to meet the extra demand brought about by increased incomes. The multiplier can be explained with the help of savings investment diagram, as has been shown in Fig. Thus, Keynesian theory of multiplier helps a good deal in explaining the movements of trade cycles or fluctuations in the economy. Inducement to invest (Investment function). 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. Privacy Policy3. Thus, the deficiency in private investment which leads to the state of depression and underemployment equilibrium will now be made up and a state of full employment will be restored. It was English economist J.M. Content Guidelines 2. 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. 50 crores in the first instance due to more saving by them implies that the producers and sellers of goods and services will find their income to fall by Rs. Thus, we see that the income will not increase by only Rs. The second major breakthrough of the 1930s, the theory of income determination, stemmed primarily from the work of John Maynard Keynes, who asked questions that in some sense had never been posed before.Keynes was interested in the level of national income and the volume of employment rather than in the equilibrium of the firm or the allocation of resources. With such a diagram we can explain the multiplier. We have seen above that as a result of increase in investment, the level of income increases by a multiple of it. It will be observed from Fig. Two Limiting Cases of the Value of Multiplier: There are two limiting cases of the multiplier. Ramesh singh chapter 5, Visvesvaraya plan, Gandhi plan, Bombay plan , Sarvodaya plan for upsc IAS - Duration: 21:09. 25 crores. Similarly, Dr. D.R. Now suppose that there is an increase in investment by the amount II”. Therefore, multiplier here is equal to 5. But the reverse process will not stop here. As a result, aggregate expenditure curve AE shifts upward to AE1 and determines new equilibrium GNP level equal to Y2. Note that the value of multiplier ∆Y/∆I will remain constant as long as marginal propensity to consume remains the same. The amount of investment undertaken depends not only on expected returns but also on the cost of capital, that is, the interest rate. It will be readily apparent from Fig. Assuming that ASF is constant, the main basis of Keynesian theory is that employment depends on aggregate demand which itself depends on two factors : 1. In our example quoted above, where marginal propensity to consume is equal to 3/4 and marginal 3/4 propensity to import is equal to 1/4, the multiplier is: We, therefore, see that the size of multiplier instead of being equal to 4, as it would have been in the case of a closed economy, is equal to 2 in the open economy with — as the marginal propensity to import. Consumption is an affine function of income, C = a + bY where the slope coefficient b is called the marginal propensity to consume. Interest rates and planned capital investment The Keynesian theory of investment places emphasis on the importance of interest rates in investment decisions. 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”. Marginal propensity to consume has been here assumed to be equal to 1/2 i.e., 0.5. In our analysis we have assumed that the planned investment is fixed, that is, determined outside the model. If the market rate of interest is 10%, is it to your advantage to purchase the asset? But this may or may not happen. Price inflation constitutes another important leakage in the working of the multiplier process in real terms. Thus, multiplier =∆Y/∆I =1/ 1-b equals marginal propensity to save (MPS) the value of investment multiplier is equal to 1/1-b = 1/s where s stands for marginal propensity to save. 100 crores, the national income increases by Rs. Now suppose that expecting hard times ahead all people try to save more by the amount of Rs. 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. 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. The concept of the change in aggregate demand was used to develop the Keynesian multiplier. 80 crores will also in turn spend these incomes, depending upon their marginal propensity to consume. It makes the two sides of the above equation equal. 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. The multiplier is, therefore, the ratio of increment in income to the increment in investment. This will increase incomes of the people equal to Rs. According to the classical theory there are three determinants of business investment, viz., (i) cost, (ii) return and (iii) expectations. This will enable them to make more profit by venturing out in those areas where demand for consumer goods is picking up. J.M. Given the demand function for money (Md), the decline in the real money supply will cause rate of interest to rise. 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. However, as more and more capital is used in the production process, the MEC will fall due to diminishing marginal product of capital. This induces them to spend less. They have developed an alternative theory of investment in terms of the profit- maximising behaviour of a firm under perfect competition. 10.4, where 55 is the saving curve with a slope equal to 0.5, and II is the planned investment curve. The incomes used for paying back the debts do not get spent on consumer goods and services and therefore leak away from the income stream. Much of wealth is held in the form of bank deposits, bonds and shares of companies and other assets. 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. In other words, there will be more demand for food-producing and textile-producing machines. 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. Share Your PDF File The Keynesian Explanation of Great Depression: The Impact of Multiplier: Limitations of Working of Keynesian Multiplier in the Developing Countries. F.A. 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. 400 crores, multiplier is 4. It will be seen from Fig. If the supply price of capital goods changes over time it becomes necessary to draw a distinction between MEC and marginal efficiency of investment (MEI). 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. This aspect was neglected by economists for over 100 years. 10.1. According to Keynes, interest is a monetary phenomenon and is determined by the demand for and the supply of money. Thus, monetarists claim that monetary policy will be effective in influencing the level of investment. Further, we have assumed that there is no any time-lag between the increase in investment and the resultant increment in income. In this way increase in demand resulting from investment would not lead to rise in prices but will cause real output to rise. 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). Now, the question is why the increase in income is many times more than the initial increase in investment. 100 crores, total national income increases by Rs. Cite this chapter as: Fletcher G.A. Macroeconomics is the study of the factors applying to an economy as a whole. determination of employment v. determination of income and output vi. Lastly, rise in price level in the domestic economy will adversely affect exports of a country causing net exports to fall. It is easy to explain this. The Keynesian perspective focuses on aggregate demand. Since marginal propensity to save is here equal to1/2 the multiplier on the basis of our above formula, namely, k =1/ MPS will be equal to 2. If ∆I stands for increment in investment and ∆Y stands for the resultant increase in income, then multiplier is equal to the ratio of increment in income (∆K) to the increment in investment (∆I). YFY1 is twice that of HT. For example, if investment equal to Rs. In Keynesian study the symmetry level of employment and earnings is ascertained at the point of equality between saving and investment. Suppose Government undertakes investment expenditure equal to Rs. 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. Keynesian economics. Before publishing your Articles on this site, please read the following pages: 1. The proportion of increments in income spent on the imports of consumer goods will generate income in other countries and will not help in raising income and output in the domestic economy. 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. 10.3. 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. The total cost will amount to Rs. Only after the Keynesian prescription to ward off depression and involuntary unemployment, namely, launching by the Government public works programme financed by the deficit budgets to raise aggregate demand, such as adopted under New Deal Policy in the U.S.A. proved to be a great success that economists and intellectuals were convinced about the validity of the Keynes’ explanation of depression. 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. 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. However, it may be noted that even in the fifties and early sixties the view that Keynesian multiplier did not work in the under developed countries did not go entirely unchallenged. 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. This paper starts by examining Keynes’ General Theory of Employment and will then illustrate how Keynesian economic theory influenced Australian government economic policy development 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. 80 crores on consumer goods, which would increase incomes of those people who supply consumer goods equal to Rs. 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. It is because of this that the role of the Government has greatly increased for overcoming recession in the capitalist countries. With the decrease in planned saving by Rs. 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. It is important to note that level of income does not drop only by the amount (E1A or RS. 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. Share Your Word File Therefore, change in consumption can occur only if there is change in income. The third condition required for the working of multiplier in real terms was that there should be involuntary open unemployment so that when aggregate demand for goods increases as a consequence of new investment, the adequate supply of workers must be forthcoming to be employed in the production processes of various industries. The MEC is the rate of return at which a project is expected to break­even. This sets in motion the operation of the multiplier in the reverse and as will be seen from the 10.4, the new equilibrium is reached at the new lower level of income Y2 (Rs. The effect of increase in consumption demand on expansion in investment is generally referred to as accelerator. First, we have assumed that the marginal propensity to consume remains constant throughout as the income increases in various rounds of consumption expenditure. Imports are important leakage from the multiplier process and we have ignored them in our above analysis for the purpose of simplicity. If these extra savings, for reasons mentioned above, result in more investment, the investment curve will shift to I’I’, the new equilibrium will be at point A corresponding to the original level of income Y1. 18.1(b), and investment will increase from OI2 to OI0. (c) There exist involuntarily unemployed workers searching for work and. Hence it was difficult to increase agricultural production in response to the increase in demand through the multiplier effect of increase in investment. As a result, consumption expenditure declines due to this wealth effect. This explains the paradoxical feature of an economy gripped by recession. 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. But when the rate of interest drops to R1, investment hikes to OI2. In fact, the acceleration principle suggests that a small increase in the demand for consumer goods leads to an accelerated increase in the demand for capital goods. The classical economists attributed this unemployment and depression to the higher wage rates maintained by the trade unions and the Government. Thus commenting on Dr. Rao’s article, Dr. K.N. It may be noted that e varies directly with r and inversely with C0, i.e., the initial cost of purchasing the machine. Rao, Dr. A.K. Propensity to consume (Consumption function) 2. 10.3. Keynesian Economics is an economic theory of total spending in the economy and its effects on output and inflation developed by John Maynard Keynes. 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. 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. Let us make an in-depth study of the Keynesian Theory of Investment. So this argument for failure of multiplier to work in real terms no longer holds good in the present economic situation. The potential for increasing raw materials and intermediate products such as cement, steel and fertilizers has significantly increased to meet the rising demand for them. Multiplier in an Open Economy = 1/ 1 -(MPC-MPI) = 1/1 – MPC + MPI. So even small changes in interest rates will have significant impact upon investment (the marginal efficiency of capital/investment curve being very shallow). That is, increment in income takes place instantaneously as a result of increment in investment. 100 crores only but a multiple of it. 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. 50 crores), that is, by the extent of reduction in consumption due to more saving but by a multiple of it. 18.1 at an interest rate of 20% only 0I0 amount of investment is worthwhile. (b) What will be the increase in national income if investment increases by Rs. 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. 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. Thus, it was often asserted in the past that Keynesian theory of multiplier was not very much relevant to the conditions of developing countries like India. Raj remarked that “Discarding the Keynesian thesis as altogether inoperative in under developed countries is really throwing the baby away with the bath water”. But every additional increase in income will be progressively less since a part of the income received will be saved. 100 crores, which was initially invested in the construction of roads, but by many times more. Its main tools are government spending on infrastructure, unemployment benefits, and education. The increments in income which the people receive as a result of increase in investment are also in part used for payment of taxes. 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”. If e exceeds r, an income-earning asset like a machine should be purchased. 2. 100 crores. 585 at the end of the second year (and zero thereafter). But other factors also enter into the model - not least the expected profitability of an investment project. Suppose the level of autonomous investment in an economy is Rs. The term R is called by Keynes the expected (prospective) rate of return on new investment (the machine) and C0 is the purchase price of the machine. Disclaimer Copyright, Share Your Knowledge Inability to meet the rise in demand for food grains would cause rise in price level or inflation in the economy rather than increase in real output. But Keynes later further refined it. 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. In this way, the chain of consumption expenditure would continue and the income of the people will go on increasing. The multiplier theory of Keynes helps a good deal in explaining this paradox. 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. The Keynesian multiplier effect is very small in developing countries like India since there is not much excess capacity in consumer goods industries. The level of national income dropped from $ 315 billion in 1929 to $ 222 billion in 1933 at 1972 prices, a decline of $ 93 billion in just four years. 10.2 will reveal that the increase in income Y1 Y2 is greater than the increase in investment by II”. 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. Explain your answer. The multiplier is the reciprocal of one minus marginal propensity to consume. However, this explanation did not prove to be valid. Thus. Thus, multiplier = 1/1 – MPC = 1/1 – 3/4 = 4. We explain below the various leakages that occur in the income stream and reduce the size of multiplier in the real world. When investment in an economy rises, it has a multiple and cumulative effect on national income, output and employment. 150 crores) has once again fallen to the original level of Rs. Now, higher the marginal propensity to consume (b) (or the lower the value of marginal propensity to save (s), the greater the value of multiplier. 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. If as a result of the investment of Rs. Keynes, however, propounded the concept of multiplier with reference to the increase in total income, direct as well as indirect, as a result of original increase in investment and income. 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. The following factors affect a firm’s investment decisions: If managers are more optimist about the future, they will place more orders for machines. However, we shall discuss later that this old view about the working of Keynes’ multiplier is not fully correct. Disclaimer Copyright, Share Your Knowledge If their marginal propensity to consume is also 4/5, then they will spend Rs. Anything which increases a firm’s profit prospects by increasing R will increase its level of investment. The decline in consumption expenditure of the people by 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 size of multiple is determined by the value of marginal propensity to consume. 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. If as a result of investment of Rs. 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. In this case, the size of multiplier will be equal to infinity, that is, a small increase in investment will bring about a very large increase in income and employment so that full employment is reached and even the process goes beyond that. 200 crores). Suppose marginal propensity to consume of the people is 4/5 or 80%. Keynesian explanation of paradox of thrift has been shown in Fig. keynesian … Rao and some others explained that in developing countries like India Keynesian multiplier did not work in real terms, that is, does not operate to increase income and employment by a multiple of the initial increase in investment. Consider Fig. But besides saving, there are other leakages in the process of income generation which reduce the size of the multiplier. The Concept of Investment Multiplier: The theory of multiplier occupies an important place in the modern theory of income and employment. 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). 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. Keynes who radically departed from the classical thought and put forward the view that it was the large decline in investment that caused the depression and substantial increase in involuntary unemployment. Consequently, the size of multiplier is smaller than that of simple Keynesian multiplier with a given fixed price level. S = f (Y). The multiplier effect in case of upward sloping curve is shown in Fig. where a is a constant term, b is marginal propensity to consume which is also assumed to remain constant. We have explained above the views of some eminent Indian economists, such Dr. V.K.R.V. In Fig. 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). 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. presentation on keynesian theory 1. guided by: mrs. rajni mam presented by: neha sharma 30/15 2. i. classical theory ii. (b) How much increase in income will occur as a result of increase in investment by Rs. Besides, in developing countries like India, there is not much excess capacity in many consumer goods industries, especially in agriculture and other wage-goods industries. 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. Before publishing your Articles on this site, please read the following pages: 1. 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. Changes in interest rates should have an effect on the level of planned investment undertaken… We can express this in a general formula. The drastic drop in private invest­ment appears to be the basic reason for the huge fall in aggregate demand or spending. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. The level of national income is determined by the equilibrium between aggregate demand and aggregate supply.   Keynesians believe consumer demand is the primary driving force in an economy. 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. 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. 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. Therefore, as a result of sharp decline in investment by $ 47.5 billion and consequently operation of the multiplier in the reverse there was a fall in the induced consumption expenditure. 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. In this case, the value of the multiplier will be equal to one. In developing countries like India the extra incomes and demand are mostly spent on food-grains whose output cannot be increased so easily. Lastly, it was pointed out that the under developed countries like India had predominantly agricultural economies and income elasticity of demand for food grains was very high in these economies. 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. This is because a part of expansionary effect of GNP of the increase in autonomous government expenditure is offset by rise in the price level. 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. To get rid of depression and remove unemployment, Government investment in public works was recommended even before Keynes. 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. It may be further noted that steeper the slope of the short- run supply curve, the greater is the increase in the price level and smaller is the effect on real GNP. Multiplier = ∆Y/∆I = Y1 Y2/II, 1/MPS =2. Therefore, the multiplier is reduced to the extent of price inflation. 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. 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. where MFC stands for marginal propensity to consume and MP1 for marginal propensity to import. The significant point to note is that investment not only creates demand but it also creates production capacity. 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. 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. Now, the rise in interest will induce private investment expenditure to decline. 10.3 aggregate expenditure curve AE0 intersects 45° line at point Sand determines Y0 equilibrium level of GNP. 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. Welcome to EconomicsDiscussion.net! 200 crores. 25 crores, national income will rise by 25 x 4 = 100 crores. Recall that real GDP can be decomposed into four component parts: aggregate expenditures on consumption, investment, government, and net exports. 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. To begin with, in the top panel of Fig. In fact the income-expenditure approach (Y = С + I) is the same thing as the saving-investment approach. The multiplier tells us how much increase in income occurs when autonomous investment increases by Rs. The disguisedly unemployed workers who are supported by joint family system could not be easily shifted to be employed in the industries for expansion of output to achieve the multiplier effect. This is because the demand for capital (investment) goods is a derived (indirect) demand. 18.1). 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. In this model savings does not come before investment. 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. Saving-Investment Approach: Introduction: An alternative to the Keynesian income-expenditure theory is the saving investment approach to income theory. 10.5 the new equilibrium level of income may not fall and therefore the paradox of thrift is averted. Keynesian Theory of Interest. Suppose marginal propensity to save of an open economy is 1/4, i.e., marginal propensity to consume is 3/4. How much national income or GNP increases as a result of any autonomous expenditure such as government expenditure, investment expenditure, net exports is determined by a shift in aggregate demand curve by the size of simple Keynesian multiplier when price level is fixed. Some Keynesian economists argue that investment depends largely upon expected return and is not very interest rate sensitive, so that even large changes in interest rates have little effect upon investment (the marginal efficiency of capital curve being very steep). Keynes has showed that if all people in a society decide to save more, they may actually fail to do so but nevertheless reduce their consumption. In fact, during the depression period of 1930s, it actually happened so and is evident from Table 10.1. Furthermore, it was asserted by Dr. Rao, the existence of disguised unemployment in underdeveloped countries instead of Keynesian type involuntary open unemployment also prevented the working of multiplier in real terms. 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. 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. The people who receive Rs. The multiple increase in income and demand will also encourage the increase in private investment. However, as shall be seen from Fig. 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. 100 crore and consumption is given by C = 10 + 0.6Y (where C = consumption and Y = income). The investment has been taken to be a constant amount and autonomous of changes in income. The multiplier is illustrated in Fig. Thus, this will further increase incomes of some other people equal to Rs. That is, in this case, the increment in income will be equal to the original increase in investment and not a multiple of it. (d) Sufficiently elastic agricultural output. This downward shift in the consumption function brings about an upward shift by Rs. Welcome to EconomicsDiscussion.net! In this figure C represents marginal propensity to consume. As a result, the theory supports the expansionary fiscal policy. However, this is unlikely to occur since marginal propensity to consume in the real world is less than one. 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. If OY 2 is assumed to be the full employment level of income then the equality between saving and investment will take place at E 2 where I 2 E 2 investment equals Y 2 E 2 saving. 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. Introduction to Keynesian theory and Keynesian Economic Policies Engelbert Stockhammer Kingston University . Therefore, multiplier is equal to 1/ 1- MPC =1/MPC. To note that the saving which had risen to Y1A ( Rs so! 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