MULTIPLIER PART II

Assumptions

• MPC remains constant throughout as income increases.
• There is no time lag between the increase in investment and the resultant increment in income.
• Excess capacity exists in the consumer goods industries so that when demand for them increases, more amount of consumer goods can be produced.
• We have taken a closed economy for our analysis because imports are an important leakage from the multiplier process.
• Prices of goods have been assumed to be constant. 

Leakages in the Multiplier process

• Paying off debts by businessmen - Since the increment in income is not spent on consumer goods.
• Holding of idle cash balances - People keep a part of their income for precautionary(contingency) motive and speculative motive.
• Imports - Income is spent on buying consumer goods produced by other countries and doesn't help in raising domestic economic activity.
• Taxation - As decided by the government in its budget.
• Increase in prices - If the production of consumer goods cannot be increased, the multiplier effect will only lead to rise in demand which will lead to inflation.

Factors Affecting the Value of Multiplier 
The value of the multiplier depends upon the following factors:
1. Propensity to Consume - Propensity to consume is the chief factor which determines the size of multiplier. The higher is the propensity to consume domestically produced goods and services, the greater is the multiplier effect. Propensity to consume is in turn determined by factors like, income of the consumer, wealth, prices, taxes etc. The government can influence the size of the multiplier through changes in tax rate which affect the disposable income of people. This is because a cut in the rate of income tax will increase the amount of extra income that can be spent on further goods and services.
2. Propensity to Save - Saving is what is left after consumption spending has been done. Propensity to save is inversely related to the value of multiplier. A higher propensity to save leaves less for consumption and multiple effect of a change in any autonomous component falls.
 3. Propensity to Import - Another factor affecting the size of the multiplier effect is the propensity to purchase imports. If, out of extra income, people spend a major part of their money on imports, this demand is not passed on in the form of fresh spending on domestically produced output. This is represented as a leakage from the circular flow of income and spending and reduces the size of the multiplier. This implies that higher the propensity to import lower will be the multiplier.
4. Available Excess/Spare Capacity - An important prerequisite for the multiplier process is that there should be sufficient spare capacity for extra output to be produced. If short-run aggregate supply (SRAS) is inelastic, the full multiplier effect is unlikely to occur, because increases in AD will lead to higher prices rather than a full increase in real national output. In contrast, when SRAS is perfectly elastic a rise in aggregate demand causes a large increase in national output.
5. Magnitude of Crowding out - Crowding out occurs whenever an expansionary fiscal policy of the government fails to have full multiplier effect on the economy due to rise in interest rate which crowds out the private investment in the economy. In our analysis we assumed investment (I) to be autonomous but it is interest rate determined. Any increase in interest rate reduces investments. Thus, (for example) increased government spending or lower taxes can lead to a rise in government borrowing and/or inflation which causes interest rates to rise and has the effect of slowing down economic activity. A higher interest rate sensitivity of investment to interest rate causes more crowding out.

So, the multiplier effect will be larger when
1. The propensity to spend extra income on domestic goods and services is high.
2. The marginal rate of tax on extra income is low.
3. The propensity to spend extra income rather than save is high.
4. The propensity to import out of extra income is low.
5. Consumer confidence is high (this affects willingness to spend gains in income).
6. Businesses in the economy have the capacity to expand production to meet increases in demand.

Importance of Multiplier

• Explains the upward and downward swings of the trade cycles.
• Important for setting the fiscal policy stance. Investment by the government in public works will solve the problem of unemployment and depression. This further induces private investment.
• FDI helps accelerating growth in developing countries.

Limitations of the working of Keynesian Multiplier in the Developing countries

• Multiplier doesn't work in real terms since there is little excess capacity and the supply of output is inelastic.
• Supply of raw materials and finance is insufficient.
• Existence of disguised unemployment poses a problem since labour cannot be readily shifted to the industrial sector.
• Developing economies are predominantly agricultural and income elasticity for foodgrains is very high. But the supply of agricultural goods is inelastic since their supply depends on natural factors.