The multiplier and acceleration theories are indispensable tools in business cycle analysis. They are helpful not only for an understanding of the dynamic process of income formation but also for policy making with respect to the stabilisation of aggregate demand.
The multiplier theory explains the cumulative effects of changes in investment on income via their effects on consumption expenditures while the acceleration theory has to do with the expanded demand for capital goods derived from net changes in the demand for consumer goods.
The idea of the multiplier originated as an explanation of the favourable effects of public investment on aggregate employment but it has become part of the general theory of the dynamic process of income propagation due to any injection of purchasing power from outside current income.
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More specifically, the concept of the multiplier is derived from the concept of the marginal propensity to consume and refers to the effects of changes in capital outlays on aggregate income through their effects on the demand for consumer goods.
Since the multiplier has to do with the effects of changes in investment on consumption expenditures, it is no surprise that the multiplier should be related to the MPC or to its inverse, the marginal propensity to save.
The value of the multiplier is determined by the MPC. The multiplier is the ratio of the change in income to the change in investment.
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This ratio will be higher the higher the MPC. If the MPC is equal to 1/2, the value of the multiplier is 2. If the MPC is equal to 2/3, the multiplier is 3 and so on.
If we know the value of the MPC, it is not difficult to estimate by now much an increase in aggregate investment will increase aggregate income.
When the MPC is zero, the multiplier is unity and the induced consumption expenditures are zero. In this case, since nothing is spent out of the extra income from the initial investment, the change in investment has a zero multiplier effect on aggregate income.
The multiplier operates backward or forward depending on the direction of the initial change in investment. If investment decreases by Rs. 10 crores, those” engaged in the production of consumer goods will have that much less income than before.
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With a MPC of 1/2 and a multiplier of 2, consumption expenditures would decrease on a 50 per cent basis in each round until aggregate income decreased by Rs. 20 crores.
Thus the initial reduction in investment precipitates the reverse opera don of the multiplier. Thus the higher the MPC, the greater the value of the multiplier and greater also the cumulative decline of income.
We have seen that the magnitude of the multiplier is determined by MPC or its inverse, the MPS. The MPS in this context refers to all kinds of “leakages,” which influence the multiplier effect via their influence on consumption. In general, the higher the MPS, the smaller the value of the multiplier and the smaller also the cumulative effect of the initial change in investment on income.
The increase in investment may be prevented from having a significant multipliers effect on consumption and therefore on income, if that increase leaks out in each re-spending round through (a) debt cancellation (b) accumulation of idle cash balances (c) net imports and (d) price inflation.