Macroeconomics

& Business
Environment
Mugdha Vaidya
IBS, Mumbai
Multiplier
• When aggregate expenditure increases the effect on national income is in
multiples of that initial increase
• The multiplier is the amount by which equilibrium output changes when
autonomous aggregate demand increases by one unit
• The size of this effect depends upon marginal propensity to consume (mpc)
∆𝐴𝐷 = ∆𝐴𝐸 +b ∆𝐴𝐸+𝑏 2 ∆𝐴𝐸+ 𝑏 3 ∆𝐴𝐸……..
= ∆𝐴𝐸(1+b+ 𝑏 2 + 𝑏 3 ……)
1
∆𝐴𝐷= ∆𝐴𝐸
1−𝑏
1 1
• Hence multiplier= or
1−𝑏 1−𝑚𝑝𝑐
Investment Multiplier
• Amount of change in equilibrium level of income due to change in
autonomous aggregate investment by one unit
Δ𝑌
• Investment multiplier= Where the multiplier >1
Δ𝐼
• It implies that one unit change in aggregate autonomous investment
causes more than proportionate change in national income
• The size of the multiplier depends upon household's marginal
propensity to consume (MPC)
𝟏 𝟏
• Investment Multiplier= 𝟏−𝒃 or 𝟏−𝒎𝒑𝒄
Deriving Investment Multiplier
• two sector economy- no government sector and foreign trade
𝑌 =𝐶+𝐼
∆𝑌 = ∆𝐶 + ∆𝐼 ….(∆𝑌0 =𝑌′0 − 𝑌0 )
𝐶 = 𝐶ҧ + 𝑏𝑌 (no taxes so 𝑌𝐷 is same as Y)
∆𝐶= 𝑏∆𝑌
∆𝑌 = 𝑏∆𝑌 + ∆𝐼
∆𝑌 − 𝑏∆𝑌 = ∆𝐼
∆𝑌(1-b)= ∆𝐼
Δ𝑦 1
=
Δ𝐼 1−𝑏

𝟏 𝟏
• Investment Multiplier= 𝟏−𝒃 or 𝟏−𝒎𝒑𝒄
The Multiplier and Paradox of Thrift
• Thrift is believed to be a ‘virtue’ by classical economists for both
individuals as well as an economy as it was believed to help increase
wealth in the economy
• It was criticized by Keynes who argued that if everyone in the
economy became thrifty
• ↑Savings → ↓Consumption → ↓AD → ↓Income/Output
&
↓Income/Output → ↓ Savings
The Multiplier and Paradox of Thrift
• Is a contradiction where ‘virtue’ for an individual is ‘harm’ for an
economy
• Reverse multiplier effect with decrease in savings
• It occurs only when increase in savings is not accompanied by
increase in investment
• If there is simultaneous increase in investment, then through
multiplier effect income and savings both increase
Presence of Government sector
• Introduction of government as a key economic player along with
households and firms
• Government expenditure / Spending includes goods purchased by central ,
state and local governments and payments made to government
employees and is determined autonomously
• Taxes include taxes on property, income and goods – Direct and Indirect
• Transfers include payments that do not involve any direct services by the
recipient , e.g. welfare payments, unemployment insurance etc
• Taxes are leakages like savings and government expenditures are injections
like investments
• Taxes and transfers affect disposable income 𝑌𝐷 = Y+TR-TA
Presence of Government sector
• Though government expenditure has an expansionary effect, taxes
have a contractionary effect on income
• However contractionary effect of taxes is less than expansionary
effect of government expenditure because- – Government
expenditure is entirely an addition to AD – Increase in Tax is not
entirely decrease in AD, part of it is absorbed by decrease in savings
and only part is absorbed by reduction in consumption i.e. AD
• When transfer payments are introduced it has a similar effect of
government expenditure on income level
Equilibrium income in the presence of
Government sector
• When taxes are paid in lumpsum

𝑌 =𝐶+𝐼+𝐺
𝐶 = 𝐶ҧ + 𝑏𝑌𝐷
ത 𝑇𝑅
𝑌𝐷 = 𝑌 − 𝑇+

𝑌 = 𝐶ҧ + 𝑏(𝑌 − 𝑇+ത 𝑇𝑅) + 𝐼 ҧ + 𝐺ҧ

𝑌 − 𝑏𝑌 = 𝐶ҧ − 𝑏𝑇ത + 𝑏𝑇𝑅 + 𝐼 ҧ + 𝐺ҧ
1
𝑌= (𝐶ҧ − 𝑏𝑇ത + 𝑏𝑇𝑅 + 𝐼 ҧ + 𝐺)ҧ
1−𝑏
Equilibrium income in the presence of
Government sector
• When proportional taxes are paid
𝑌 =𝐶+𝐼+𝐺
𝐶 = 𝐶ҧ + 𝑏𝑌𝐷
𝑌𝐷 = 𝑌 − 𝑡𝑌 + 𝑇𝑅

𝑌 = 𝐶ҧ + 𝑏(𝑌 − 𝑡𝑌 + 𝑇𝑅) + 𝐼 ҧ + 𝐺ҧ
𝑌 = 𝐶ҧ + 𝑏 1 − 𝑡 𝑌 + 𝑏𝑇𝑅 + 𝐼 ҧ + 𝐺ҧ
𝑌 − 𝑏 1 − 𝑡 𝑌 = 𝐶ҧ + 𝑏𝑇𝑅 + 𝐼 ҧ + 𝐺ҧ
1
𝑌= (𝐶ҧ + 𝑏𝑇𝑅 + 𝐼 ҧ + 𝐺)ҧ
1−𝑏 1−𝑡
Fiscal Multipliers- Government expenditure
multiplier
• Change in government expenditure leads to change in AD and hence
also a change in national income
𝟏 𝟏
• The size of change depends upon or 𝟏−𝒎𝒑𝒄 , when taxes are paid
𝟏−𝒃
in lumpsum
𝟏 𝟏
• The size of change depends upon or , when
𝟏−𝒃(𝟏−𝒕) 𝟏−𝒎𝒑𝒄(𝟏−𝒕)
proportional taxes are paid
• Transfers are considered autonomous
• Since 0<b<1, Government expenditure multiplier is greater than 1
Deriving Government expenditure multiplier
𝑌 =𝐶+𝐼+𝐺
∆𝑌 = ∆𝐶+ ∆𝐺 …(since investment is exogenous and constant, 𝐼)ҧ
∆𝑌 = b∆𝑌𝐷 + ∆𝐺
ത 𝑇𝑅 …(when lumpsum tax is paid and transfers are
𝑌𝐷 = 𝑌 − 𝑇+
autonomous)
Hence, ∆𝑌 = b∆Y + ∆𝐺
∆𝑌 − 𝑏∆Y= ∆𝐺
∆𝑌(1-b)= ∆𝐺
𝜟𝒚 𝟏
=
𝜟𝑮 𝟏−𝒃
Deriving Government expenditure multiplier
𝑌 =𝐶+𝐼+𝐺
∆𝑌 = ∆𝐶+ ∆𝐺 …(since investment is exogenous, 𝐼)ҧ
∆𝑌 = b∆𝑌𝐷 + ∆𝐺
𝑌𝐷 = 𝑌 − 𝑡𝑌+ 𝑇𝑅…(when proportional tax is paid and transfers are
autonomous)
Hence, ∆𝑌 =b(1-t) ∆Y + ∆𝐺
∆𝑌 − 𝑏 1 − 𝑡 ∆Y= ∆𝐺
𝜟𝒚 𝟏
=
𝜟𝑮 𝟏−𝒃(𝟏−𝒕)
Fiscal Multipliers: Tax Multiplier
1
1. 𝑌 = (𝐶ҧ ҧ Equilibrium income in the presence of the Government sector
− 𝑏𝑇ത + 𝑏𝑇𝑅 + 𝐼 ҧ + 𝐺)..
1−𝑏
1
2. 𝑌 + ∆𝑌 = ( 𝐶ҧ + 𝑏𝑇𝑅 + 𝐼 ҧ + 𝐺ҧ − 𝑏(𝑇ത + ∆𝑇)… If tax changes by ∆𝑇
1−𝑏
Hence,
1
∆𝑌 = (−𝑏(∆𝑇)
1−𝑏
𝚫𝒀 −𝒃
𝑮𝑻 = =
𝚫𝑻 𝟏−𝒃
Fiscal Multipliers- Balance Budget Multiplier
• Tax multiplier is negative hence increase in Tax causes decrease in the
equilibrium level of income
• The budget is in balance when government expenditures plus transfer
payments are equal to the gross tax receipts , G=T
• Therefore, increase in government expenditure is financed by
increase in taxation ∆G=∆T
• Balance Budget multiplier is the increase in income as a result of
increase in government expenditure and taxes , its value is equal to 1
• Regardless of value of b, Government expenditure multiplier > Tax
multiplier
Fiscal Multipliers- Balance Budget Multiplier
Balanced budget multiplier= Government expenditure multiplier + Tax
multiplier
Introduction of Foreign sector – Open
economy
• Equilibrium Income when Lumpsum tax paid
Y= C+I+G+X-M
Y= C+ 𝐼 ҧ + 𝐺ҧ + 𝑋ത -M
M=𝑀+ ഥ mY
𝐶 = 𝐶ҧ + 𝑏𝑌𝐷
ҧ
Y= 𝐶+b(𝑌 ത 𝑇𝑅) + 𝐼 ҧ + 𝐺+
− 𝑇+ ҧ 𝑋ത -( 𝑀+
ഥ mY)
𝑌 − 𝑏𝑌 + 𝑚𝑌 = 𝐶ҧ − 𝑏𝑇ത + 𝑏𝑇𝑅 + 𝐼 ҧ + 𝐺ҧ + 𝑋ത − 𝑀 ഥ
1
𝑌= (𝐶ҧ − 𝑏𝑇ത + 𝑏𝑇𝑅 + 𝐼 ҧ + 𝐺+ ҧ 𝑋ത − 𝑀)
ഥ
1−𝑏+𝑚
Introduction of Foreign sector – Open
economy
• Equilibrium Income when Proportional tax paid
Y= C+I+G+X-M
Y= C+ 𝐼 ҧ + 𝐺ҧ + 𝑋ത -M
M=𝑀+ ഥ mY
𝐶 = 𝐶ҧ + 𝑏𝑌𝐷
𝑌𝐷 = 𝑌 − 𝑡𝑌 + 𝑇𝑅

𝑌 = 𝐶ҧ + 𝑏(𝑌 − 𝑡𝑌 + 𝑇𝑅) + 𝐼 ҧ + 𝐺+
ҧ 𝑋-(
ത 𝑀+ഥ mY)

𝑌 = 𝐶ҧ + 𝑏 1 − 𝑡 𝑌 + 𝑏𝑇𝑅 + 𝐼 ҧ + 𝐺+ҧ 𝑋-(

ത 𝑀+
ഥ mY)
𝑌 − 𝑏 1 − 𝑡 𝑌 + 𝑚𝑌 = 𝐶ҧ + 𝑏𝑇𝑅 + 𝐼 ҧ + 𝐺+ ҧ 𝑋-
ത 𝑀ഥ
1
𝑌= (𝐶ҧ + 𝑏𝑇𝑅 + 𝐼 ҧ + 𝐺+ҧ 𝑋−
ത 𝑀)
ഥ
1−𝑏 1−𝑡
Foreign Trade Multiplier
• Increase in income levels in other countries leads to increase in exports of
domestic economy
• This leads to increase in domestic production leading to increase in income
which further adds to increase in consumption(depending on mpc)
• Part of this increase is directed towards imports depending upon marginal
propensity to import ( mpi)
• This leads to second stage of expansion , though leakage in the form of imports
would restrict the expansion in income
• Further increases in income become smaller and smaller
• The size of multiplier will be smaller when marginal propensity to import(m) is
positive
Δ𝑦 1 1
= or
Δ𝑋 1−𝑏+𝑚 1−𝑏(1−𝑡)+𝑚
Deriving foreign trade multiplier
• When Lumpsum tax paid
Y= C+I+G+X-M
Y+M= C+I+G+X
∆𝑌 + ∆M = ∆C + ∆ X …(assuming investment and government expenditure
remains constant)
∆𝑌+m ∆𝑌=b ∆𝑌+ ∆ X
∆𝑌 +m ∆𝑌 −b ∆𝑌 = ∆ X
(1-b+m) ∆𝑌 = ∆ X
Δ𝑦 1
=
Δ𝑋 1−𝑏+𝑚
Deriving foreign trade multiplier
• When proportional tax paid
Y= C+I+G+X-M
Y+M= C+I+G+X
∆𝑌 + ∆M = ∆C + ∆ X… (assuming investment and government expenditure
remains constant)
∆𝑌+m ∆𝑌=b(1-t)∆𝑌+ ∆ X
∆𝑌 +m ∆𝑌 −b(1-t) ∆𝑌 = ∆ X
[1-b(1-t)+m] ∆𝑌 = ∆ X
Δ𝑦 1
=
Δ𝑋 1−𝑏(1−𝑡)+𝑚
Uses and Limitations of multiplier
• Most important in planning economic growth
• It shows amount of additional investment required to for the level of
planned growth in national income
• However it may not work
• Lack of availability of adequate quantity of consumer goods at the right time
• Time lag in increase in supply
• Full employment ceiling