MODULE 5
THE MULTIPLIER AND THE RELATIONS BETWEEN APC, APS, MPC, AND MPS
INTRODUCTION
In economics, a multiplier broadly refers to an economic factor that, when changed,
causes changes in many other related economic variables. The term is usually used
in reference to the relationship between government spending and total national
income. In terms of gross domestic product, the multiplier effect causes changes in
total output to be greater than the change in spending that caused it.
Before we treat the concept of multiplier, it is necessary that we should understand
the relationship between APC, APS, MPC, and MPS
AVERAGE PROPENSITY TO CONSUME (APC):
Average Propensity To Consume (APC): this is the ratio of consumption to income.
Also, it is the fraction of the National Income consumed, that is,
APC = Total National consumption = C/Y
Total National Income
The average propensity to consume decrease with increasing income levels. At low
levels of income, an individual may consume almost all his income. In this case the
APC will be close to 1. But as income increases, the proportion of income consumed
will be less.
Example 1: Calculate the average propensity to consume, if the national income
is N20m and the total National consumption is N15m.
Solution:
APC = C/Y
APC = N15m/ N20m
= 0.75
Example 2: If the national income is 150m and the average propensity to consume
is 0.2. Calculate the total National Consumption.
Solution:
C = Y X APC
= N150m X0.2
= N30
1
AVERAGE PROPENSITY TO SAVE
Average Propensity To Save (APS): this is defined as measure of the proportion
of income which is saved (not spent on consumption) i.e. ratio of saving to total
income .It tells the expected amount of savings at different levels of income. The
average propensity to save increases with increases in income. As the level of
income increases one is able to save more money.
Note: APC + APS = 1.
APS = Total National Saving = S/Y
Total National Income
Example 1: If total National saving is 50m and the total national income is 500m,
then the APS will be thus;
Solution:
APS = S/Y
APS = N50m/N500m
APS = 0.1
Example 2: If an individual earns an annual income of N6,000.00 and spends
N4,000.00 on the consumption of goods and service, calculate his average
propensities to consume and to save.
Solution:
Total income = N6000.00
Consumption expenditure = N4, 000.00
APC = C/Y = 4000/6000 =2/3 = 0.67 = 67%
Since APC + APS = 1
APS= 1 –APC=1- 0.67 = 0.33 or 33%
Expected savings = N6, 000.00 – N4, 000.00 = N2, 000.00
APS = N2000.00 = 0.33
N6000.00
2
MARGINAL PROPENSITY TO CONSUME
Marginal Propensity to Consume (MPC): this is the rate of change in consumption
to income. Also, it is the fraction of the National Income consumed, that is,
MPC = ΔC/ ΔY
Example 1: Calculate the marginal propensity to consume, if the national income
change by N20m as a result of change in National consumption by N15m.
Solution:
MPC = ΔC/ΔY
MPC = N15m/ N20m
= 0.75
MARGINAL PROPENSITY TO SAVE
Marginal Propensity to Save (MPS): this is defined as measure of change in income
over the change in saving.
MPS = ΔS/ ΔY
Note: MPC + MPS = 1.
Example 1: If total National saving change by 50m as a result of change in total
national income by 500m, then the MPS will be thus;
Solution:
MPS = ΔS/ΔY
MPS = N50m/N500m
MPS = 0.1
Example 2: If an individual annual income increase from N6, 000.00 to N7,
500.00 which lead to increase in his saving from N2, 000.00 to N4, 000.00 on
the consumption of goods and service, calculate his marginal propensities to save.
Solution:
Change in Total income = N7 500.00 - N6000.00 = N1, 500.00
Change in saving = N4, 000.00 – N2, 000.00 = N2, 000.00
MPS = ΔS/ΔY = 1500/2000 = 0.75 = 75%
3
THE KEYNESIAN MULTIPLIER
Many economists believe that new investments can go far beyond just the effects
of a single company’s income. Thus, depending on the type of investment, it may
have widespread effects on the economy at large. A key tenet
of Keynesian economic theory is that of the multiplier, the notion that economic
activity can be easily influenced by investments, causing more income for
companies, more income for workers, more supply, and ultimately
greater aggregate demand.
Essentially, the Keynesian multiplier is a theory that states the economy will flourish
the more the government spends, and the net effect is greater than the exact
dollar amount spent. Different types of economic multipliers can be used to help
measure the exact impact that changes in investment have on the economy.
For example, when looking at a national economy overall, the multiplier would be
the change in real GDP divided by the change in investments, government
spending, changes in income brought about by changes in disposable income
through tax policy, or changes in investment spending resulting from monetary
policy via changes in interest rates.
Some economists also like to factor in estimates for savings and consumption. This
involves a slightly different type of multiplier. When looking at savings and
consumption, economists might measure how much of the added income consumers
are saving versus spending. If consumers save 20% of new income and spend 80%
of new income, then their marginal propensity to consume (MPC) is 0.8. Using an
MPC multiplier, the equation would be:
TYPES OF MULTIPLIERS
A multiplier may occur in a variety of ways, impacting different instruments or
balances. The most common types of multipliers are below:
1. The investment multiplier
2. The government multiplier
3. The Balanced Budget Multiplier
4. The Tax rate multiplier
WHAT IS THE MULTIPLIER FORMULA IN ECONOMICS?
The multiplier formula denotes an effect that initiates because of increased
investments (from the government or corporate levels), causing the proportional
increase in the economy’s overall income. However, it is also observed that this
phenomenon works in the opposite direction (the decrease in income affects a
reduction in total spending). Following is the formula for the calculation of the
multiplier effect:
4
Multiplier (k) = Change in Real GDP (Y) / Change in Injections
For the calculation of the multiplier formula in economics, the formula used is:
Multiplier (k) = 1 / MPS
Or
k = 1 / (1 – MPC)
Example 1
Let us assume that the government has come up with an investment of $200,000
in the infrastructure project in the country. This additional income would follow the
marginal propensity to save and consume. Therefore, calculate the multiplier if the
marginal propensity to consume is 0.8 or 80%.
Solution:
We got the following data for the calculation of multiplier.
a. Expenditure: $100,000.00
b. MPC: 0.80
Calculation of multiplier formula is as follows –
a. Multiplier Or (k) = 1 / (1 – MPC)
b. = 1/( 1 – 0.8)
c. = 1/( 0.2)
5
DERIVATION OF MULTIPLIER
The multiplier formula can be derived by using the basic income expenditure
identity for the two sector economy. Y = C + I … (6.1)
If ΔY, ΔC and ΔI denote the changes in the levels of income, consumption and
investment respectively, we have Y+ ΔY = C + ΔC +I + Δ I … (6.2)
Subtracting equation (6.1) from (6.2), we get, ΔY = ΔC + ΔI … (6.3)
The above equation indicates the change in the level of income required to attain
the new equilibrium level of income. Since the consumption function is assumed to
be linear, C = a + by. Therefore, ΔC = bΔY. In other words, the consumption
expenditure changes by an amount equal to ‘b’ times the change in the income,
where ‘b’ is the marginal propensity to consume (MPC). Thus, we have the
following:
MPS is the marginal propensity to save. Alternatively, the value of the multiplier
can be derived by dividing both sides of the equation (6.3) by ΔY. We have,
6
Thus, for given any change in the investment (ΔI), the change in the income (ΔY)
required to restore the equilibrium is known, if the value of the multiplier is known.
Further, the value of the multiplier can be known, if the value of MPC or MPS is
known. From the formula of the multiplier, it is clear that the multiplier is the
reciprocal of MPS or (1- MPC). The larger/smaller the value of the MPC/MPS, the
larger /smaller will be the value of the multiplier (as the case may be) and vice-
versa. In the developing countries, the MPC is relatively higher. So, the value of
the multiplier is higher in these countries. In other words, the rise in the income
induced by a given increase in the investment will be larger, when a greater
proportion of the additional income is spent on consumption and vice versa. For
example, if MPC = 0.5, then the value of the multiplier (K) is 1/(1-0.5) or2. If the
value of the MPC increases to 0.o75, the value of the multiplier increases and vice
– versa. It is clear from the following Table 6.2.
Table 1: Relation among MPC, MPS and Multiplier
The value of the multiplier, thus, ranges front 1 to infinity. On the one extreme,
when the marginal propensity to consume (MPC) is zero, the economy decides to
save the whole of the additional income. Here, the value of the multiplier is equal
to 1 [K = 1/ (1-0) = 1], since whole of the increase in the income (ΔY) leaks out
of the spending stream in the second round itself. Hence, there will not be any
further increase in the income. As a result, the total increase in the income will be
same as the increase in the investment. i.e., Δ Y = ΔI.
On the other extreme, if MPC = 1, the economy decides to consume the whole of
additional income. Here, the value of the multiplier is infinity. [K= 1/(1-1) = ∞]. In
this case, even a very small increment in the investment will make a tremendous
impact on the consumption expenditure and hence the income. Here, not even a bit
of the additional income is diverted into the saving. In this exceptional situation,
the expansion process is very fast and so the aggregate demand always exceeds
the aggregate supply (or the investment exceeds the saving), round after round.
This will produce extreme instability in the levels of income and output on account
of the continuously rising consumption expenditure after each round. But, the
expansion process will come to an end, the moment unemployed resources are
7
fully employed. Any pressure of the rise in demand, thereafter, will only generate
inflationary tendencies.
Both of the above extreme cases are only rare possibilities. MPC can never be
zero or one, irrespective of the level of development in the economy. MPC is the
highest in the third world countries. Even there, the saving rate is not zero, so MPC
is not equal to 1. Hence, the limiting values of 1 and infinity for the multiplier are
completely ruled out. In actual practice, MPC assumes value between 0 and 1.
Therefore, the multiplier takes values only between 1 and ∞.
Most of the economists are of the opinion that the actual value of the MPC must lie
between 0.33 to 0.9, and so the multiplier values will fall within the range of 1.5
and 10.
STUDY QUESTIONS
1. Given the model of national income as:
Y=C+I
C = 100 + 0.75Y
a. Determine the equilibrium level of National Income
b. What is the value of the multiplier?
2. Given that both APC and MPC are 0.8. What is the value of the
multiplier?
