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What does it really mean?—The Multiplier Process

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1967
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Shu-Chin Yang

THE CONCEPT of the multiplier process was first introduced into economic thought in discussions of unemployment and business cycles in industrialized countries. It has become one of the pillars of modern Keynesian economics.

It is easy to understand that an increase in investment will cause income to expand, while a decrease in investment will cause it to contract, because investment is just one part of the national income. But if we think in terms of economic dynamics, the story does not end there. An increase in investment will initiate a process by which income will eventually increase by an amount greater than the original increase in investment.

The Process

The multiplier process is a chain reaction. Suppose Mr. A decides to build a workshop and engages a building contractor, Mr. B, to do it for him. Mr. B receives from Mr. A, as the total payment for the job, the sum of $10,000. Out of the $10,000, suppose Mr. B makes a profit of $1,500; the rest he uses for paying the laborers he hires and for the building materials he buys. Mr. B will spend some of this additional income, but he will probably save a part too. The construction laborers and the wholesalers of building materials will do likewise—they will spend a part of their additional income and save the balance.

Note the impact of Mr. A’s investment upon national income and expenditures. When Mr. A gave Mr. B a check for $10,000 for a new workshop, there was an initial increase of that amount in society’s stream of income and expenditures. Furthermore, when Mr. B and his fellow laborers and merchants spend some of their income earned in the course of building Mr. A’s workshop, there will be an additional increase in income and expenditures. A further increase will follow in the next round, as Mr. C and others who sold materials and services to Mr. B will in turn spend some of their new income. This process will go on and on adding a smaller and smaller amount of income to the national income stream in each succeeding round.

The rate of increase in income declines in each round, because people will presumably always save a portion of their additional income, spending only a part. If people save only a small part of their income, spending the greater portion of it, clearly people in the following round will earn a greater income. Economists call the proportional factor which shows the portion of additional income that people tend to consume the “marginal propensity to consume.” The greater the marginal propensity to consume, the greater will be the induced income and expenditures out of the same initial investment.

Assuming that people save one fifth of their incomes and spend the rest—i.e., that the marginal propensity to consume is four fifths—we get a spending chain as shown on the following page.

In the first five periods after the initial investment, the total increase in national income will be $33,616. But eventually—as can be demonstrated mathematically—it will be $50,000.

Public Finance

Thus far the description is of a very simple economy, without taxation, for example. But of course the multiplier effect of government activities is very important. Government expenditure, taken by itself and assuming no changes in taxation (and also no offsetting decline in private investment), has a multiplier effect upon income just like that of private investment. A chain of respending can be set into motion by public road building, government engagement of additional teachers, and so on, just as effectively as by private investment in building a new workshop.

It might seem that a tax reduction which adds disposable income to the private sector would have the same effect on the amount of national product as government expenditures. But this is not so. Government expenditures add initially and immediately to the demand for goods and services, and subsequently to induced consumption, while tax reduction does not have the same initial impact. Government expenditures are a part of—and hence have a direct influence on—aggregate demand. But tax reduction in effect omits the first round; it has an indirect influence on aggregate demand, making its impact by increasing the volume of consumption expenditures (to a lesser extent it may also affect investment expenditures as well). A tax reduction of $10,000 adds the same amount to the country’s disposable income, but the persons receiving this amount would not spend the whole of this, for they tend to save a part of it.

Suppose a government expenditure of $10,000 brought about an eventual increase in incomes totaling $40,000. We know that the increase of $40,000 may be divided into two parts: $10,000 spent for government goods and services, and $30,000 spent subsequently on consumption. A tax reduction of $10,000 would bring about an eventual increase of consumption of $30,000. It would lack the initial effect of generating $10,000 of income that the government expenditure had. Because of the inclusion of the original $10,000 in the government expenditure multiplier, the multiplier will always be greater than the tax reduction multiplier by one, to reflect the original sum of investment expenditure. Similarly, working toward the contraction, the tax increase multiplier will have a smaller effect than the expenditure reduction multiplier.

A TYPICAL SPENDING CHAIN

This divergence between the expenditure multiplier and the tax multiplier leads to an important aspect of fiscal policy, which common sense observation often fails to grasp. Frequently it is contended that balancing a budget, in the sense that every change in government spending is matched by a corresponding change in taxes, will wipe out the potential inflationary pressure created by government spending. Such an argument would be valid only if the “negative” effect of taxation is wholly offset by the “positive” effect of expenditure. But it has been seen that the expenditure multiplier is always greater than the tax multiplier by one. Even if the government expenditure is solely financed by taxes, the national income and expenditures will eventually increase by the original sum of increase in government spending.

Balance of Payments

New exports also have exactly the same multiplier effects as does new domestic investment. They raise incomes directly, but in addition they set up a chain of further spending and respending. A million dollars of new orders of rubber to Malaysian rubber wholesalers will create $1 million of primary jobs and income. Workers and owners of rubber estates as well as rubber wholesalers in Malaysia will in turn spend a large portion of their additional incomes on food, clothing, and other things. Ultimately, the secondary incomes so propagated will be several times the original new export orders.

Malaysia also imports goods and services from foreign countries. No matter how the increase in domestic purchasing power is originated (either through an increase in private investment in shoe-manufacturing or through an increase in government road-building activity, or through an increase in rubber exports), some parts of the chain increases in incomes are likely to be spent and respent on imported commodities. At each step such expenditure abroad acts as “leakage” and does not generate further domestic purchasing power. To think of the multiplier process in terms of leakages is one way of understanding it.

Change in Consumption

Thus far we have assumed that a change in private consumption bears a fixed proportion to a change in the national income and that the initial economic change comes through either a change in private investment, in government expenditure, or in export. For it is believed and has been observed that generally a change in private consumption in association with a given change in national income is fairly stable.

THE INCOME MULTIPLYING PROCESS

* Domestic Consumption out of each round of income increase.

However, the propensity of any economy to consume can change either abruptly or through time. For instance, in industrialized countries it is sometimes found that consumer spending on durable goods, such as automobiles, does change independently of income change. (This is “keeping up with the Joneses” or in the economists’ shorthand, the “demonstration effect.”) Also in developing countries the propensity to consume tends to increase through time by the influence of the consumption patterns in richer countries. Any increase in private consumption independent of an increase in income will have a double effect on the subsequent increases in income because it raises the initial injection of expenditure as well as enlarging the multiplier itself.

An Illustration

There are three ways in which new income received may leak out of the system being subjected to the multiplier process. It may be spent on imported goods, paid out in taxes, or saved. If it does not leak in any of those ways it may be spent on domestic consumption goods and services. The latter expenditure, sooner or later, creates additional income.

We can then think of the effects taking place in a series of “rounds” with intervals of time between them. In each round there are the three types of leakages from the stream of income and expenditure on domestic consumption goods which create the new income available for the subsequent round.

Now, let us assume higher export earnings by a whole group of farmers, the increase in this case being 500 units. Suppose further that the proportions in which this income is disposed of are as follows:

Proportion spent on domestic consumption goods60%
The “leaks”Proportion spent on imported goods20%
Proportion paid out in taxes10%
Proportion saved10%

On these assumptions the disposition of the additional income in the first instance is set out on the first line of Table 2 under the heading “1st round.” Of the total amount, 60 per cent, i.e., 300 units, was spent on domestic consumption goods and therefore becomes a new source of income available for a “second round” of expenditure. (We assume that the government does not spend the additional tax revenue and that the private sector does not invest more.)

If we assume the same proportions as before, the second line shows what happens in the second round. If we suppose that the same process with the same proportions goes on round after round, we find that at the end of five rounds the totals at the bottom of each column are more than twice the figures for the first round. In fact, if we went on indefinitely with similar figures we would approach closer and closer to a proportion of two and a half times the first round figure. This proportion between the hypothetical total and the figures in the first round, which in this case is 2.5, is the multiplier.

We may note further that the ultimate total of taxes (125), savings (125), and imports (250) equals 500, the amount of the additional income that started the process. This, as we have seen, is no accident. These are the leakages out of the flow of new income on each round, which eventually reduce the flow to zero, so that the economy reaches equilibrium. The cumulative leakages must, there-funds. Thus we see that any new injection of fore, eventually equal the initial injection of spending cannot permanently lift the economy above its previous level. To achieve a permanent or sustained forward push there must be a continuous new injection, at a steady rate, if not from the same source then from one or more of the other active factors: investment, government expenditure, and exports.

Table 2
Private IncomeExpenditure on Domestic Consumption GoodsImportsTaxesSavings
1st round5003001005050
2nd round300180603030
3rd round180108361818
4th round10864.821.610.810.8
5th round64.838.8812.966.486.48
Total rounds 1-51,152.8691.68230.56115.28115.28
Ultimate total1,250750250125125

Employment and Capacity

The importance of the multiplier process in modern economic thinking derives from the characteristics of economic depression in industrialized countries, where there coexist large numbers of unemployed workers on the one hand and substantial excess productive capacity (in transport equipment, machinery, factory buildings, etc.) on the other. What is lacking is effective demand. Thus an increase in investment expenditure, provided it is a net increase for the public and private sectors taken together, will quickly set off a chain expansion of effective demand for goods and services. Such a multiplier process will immediately draw formerly unemployed laborers to work on the formerly unused productive capacity, and it is very easy to produce more goods to meet the increased demand. The result is simultaneous increases in both money income and real output. In a capitalist economy, the most important dynamic factor in increasing effective demand is private investment. But during a depression new incentives are needed for private businesses to increase investment, and this is why many economists nowadays favor a resort to public investment to generate the new incomes and expenditures needed to cure depression.

Money Income Versus Real Output

The effectiveness of the multiplier in increasing real output depends on the level of unemployment and the degree of utilization of capacity. The distinction between “money” and “real” effects is very important. It may be argued that, since in developing countries there are large numbers of unemployed and underemployed labor, and since investment multiplies income, it would be easy for such a country to raise its national income simply by increasing investment spending. The basic fallacy in this argument is that it overlooks one of the fundamental obstacles to economic growth of less developed countries, namely, the shortage of real capital or productive capacity. Since productive capacity is limited in these countries, a less developed economy will, if money income and expenditure keep increasing, soon be using all of this capacity. In the developed countries, where productive capacity is abundant and can be readily expanded, the effective limit to increases in real output over periods of a few months or a few years is generally set by the numbers available for employment. Output will cease to grow when everyone of working age who is able to work and wants to have a job has one. In developing countries, where capital is scarce, the limit is usually reached when productive capacity is fully utilized. It is true that in either type of country an increase in investment will in due course lead to an expansion in productive capacity. But during the gestation period, an excessive injection of investment expenditure will only expand money incomes and raise prices.

Once the limit to an increase in output has been reached (whether this is set by full employment or by full utilization of productive capacity), any attempt to increase investment still further will set up a situation where prices will tend to rise. Money income will still increase, as indicated by the multiplier, but real output will not. When real output and income are not increasing, there will also be no increase in real saving to finance real investment. Thus the real multiplier becomes nil. But the money income will still multiply, providing that investment expenditure is still increasing. In this way the money multiplier diverges from the real multiplier.

The Elasticity of Supply

While the lack of capital goods industries in developing countries makes it particularly difficult for them to create more productive capacity for industry, the problem of securing speedy increases in agricultural output may be even more serious and deep-rooted. The number of employees hired for wages is comparatively small; the vast majority of cultivators are self-employed or family-employed. A good part of the national output, especially of food, is produced not for the market but for consumption at home. An increase in cultivators’ incomes above the bare subsistence level may lead them to consume more themselves and leave less to be marketed. Or, owing to high rents or for psychological reasons, they may even prefer more leisure to higher output. The result may be a reduction in market supplies.

Agricultural output in developing countries is also very difficult to increase quickly because of persistent production bottlenecks, such as a lack of irrigation facilities or inadequate technical training, which take a long time to correct. Thus, in the short run, agricultural output depends very much on the weather.

It is true that in most developing countries, many people in the rural areas are underemployed. But, since the surplus laborers have to be trained before they can be put on other jobs, a simple injection of purchasing power cannot mobilize such labor into productive employment. Such training requires time, effort, and money, and even when they are trained, the workers have to be moved into the towns where industries are located.

The low elasticity of supply in developing countries sets a sharp limit to the effects that the multiplier process has in them. They are not at all in the same position as developed countries during a depression. In developing countries a simple increase of purchasing power cannot generate a prolonged increase in output but is apt to lead only to a quick rise in prices.

Here lies the limitation of “deficit financing” of economic development. In developing economies the real problems are how to increase productive capacity and how to produce goods more efficiently. The injection of money, by itself, is no substitute for the fundamental task of development, the task of increasing society’s capacity to produce. The achievement of this task is a long-run effort that involves not only increases in saving and investment but, equally, an increase in human skills, changes in human motivations, improvements in organizational arrangements, and the development of new institutions. It is this complex web of human and physical factors which, in combination, generates economic development.

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