The theory of multiplier and acceleration principle chapter 3, functioning of investment multiplier, the process of income generation through multiplier, acceleration principle, limitations of multiplier and acceleration.

1. THE THEORY OF
MULTIPLIER AND
ACCELERATION PRINCIPLE
Vaghela Nayan K.
SDJ International College

2. THE CONCEPT OF INVESTMENT
MULTIPLIER
The concept of Multiplier is developed by Prof. Keynes, and it is
based on the concept of Marginal propensity to consume.
It refers to the effects of changes in investment outlay on aggregate
income through induced investment expenditure.
The Multiplier expresses the relationship between an initial
increment in investment and the final increment in Aggregate
Income.
Whenever an investment is made in the economy, it leads to
increase in aggregate income not only by amount of investment but
by somewhat more than that.
The reason is that the initial investment increases the income not
only in those industries where the investment is made but also in
certain other industries whose products are demanded by people
employed in investment industries.

3. For example: If initial investment increases by `10 crores and the
aggregate income rises by `30 crores, then the multiplier is 3. In its
essence, the Multiplier is the ratio of the change in Income to the
change in Investment.
Thus, Multiplier, K = ΔY/ΔI
K= investment multiplier
ΔY= change in income
ΔI = change in investment.

4. DETERMINATION OF MULTIPLIER

6. THE PROCESS OF INCOME GENERATION
THROUGH MULTIPLIER
As said earlier there is a direct relationship between MPC and
the value of multiplier, suppose the MPC is ¾ and apparently
the value of MPS is ¼ the value of multiplier will be 4.
If the initial investment in the economy is `20 crores, the it will
create the total income of 20x4 = ` 80 Crores. This income
generation happens in two stages:
1. Primary generation of Income: When an additional investment
of `20 crores is made for the constructions like, railway line,
the different categories of people employed in this project
taken together will earn an income of `20 crores. This is
known as primary income.

7. 2. Secondary Income Generation: now, assuming MPC ¾, k15
crores will be spent by these people on food, clothing and other
consumer goods. It means k15 crores is received as income by
businessmen, shopkeepers and others. this ligic is based on the
fundamental proposition that one man’s consumption
expenditure is another man’s income. The recipients of k15
crores will be spending its ¾ part (k11.25 crores) for their
consumption and so on.
 At the end the total income generation will be k80 crores and
MPS being ¼ the total savings will be k20 crores, so that the
savings will be equal to amount of initial investment. Here the
process of income expansion comes to an end.
 This whole process of income generation is spread over a
period of time. In the above example, the aggregate income
does not increase to k80 crores at once and simultaneously,
but over a period of time.
 If each round takes 5 months to generate the income than total
k80 crores will be generated at the end of 25 months, as there

9. In the above diagram, the original equilibrium level of income
is OM at point E. Now it investment is increased by AB , the
new curve is C+I+ΔI.
As a result of this increase in investment, income increases by
MN. This is due to multiplier effect.
In the words of J. Breadshow, “The multiplier principle is that a
change in the level of injection bring about a relatively greater
change in the level of national income.”

10. Assumption of the concept of Multiplier:
1. There is change in autonomous investment. (government spending,
exports, etc.)
2. There should not be any change in the marginal propensity to
consume.
3. Positive gross investment is not enough, but there should be positive
net addition to society’s stock of capital.
4. There should be continuity in investment.
5. Steady flow of consumption goods.
6. Non existence of international trade with the rest of the world.
7. No time lag between the income receipt and consumption
expenditure made by the community.
8. Lump-sum tax system should be implemented or the effect of
multiplier will be less in case of proportionate tax system.
9. The economy operates at the situation less than full employment.

11. Leakages of Multiplier:
1. Saving: in the situation where the MPC is 1 and MPS is zero, the
entire new income generated as a result of an increase in
investment would be spent by the people in buying consumer
goods. Here the increase in income will last till the economy
attains the stage of full employment. But in practice, MPC can
hardly be 1. as people are also keen to save their part of
income. Contrary if the people will save whole of their increased
income, then there can not be investment multiplier. Higher the
MPS lower the investment multiplier.
2. Debt Repayment: according to Duesenberry, people use their
part of income for the payment of the past debts that they have
incurred. Because of this there is leakage from the income
stream and the value of multiplier gets reduced.
3. Accumulation of idle cash balance: the part of increased income
saved by the people in banks (idle cash) will not be the part of
money in circulation and therefore the value of multiplier will
come down.

12. 4. Stock exchange transactions: The income spent for purchasing of
old stock, securities and bonds by the people will not form the part
of consumption expenditure , therefore such transactions are
unlikely to increase the value of multiplier.
5. Imports: Money spent in buying imported goods does not add to
domestic income and employment. Because of this money leaks
out of the country. This limits the value of multiplier.
6. Price inflation: During inflation, money income of the community
increases but real income decreases. The real consumption
expenditure which determines the value of the multiplier will fall.
The major part of increase in money income will be neutralized by
price inflation instead of stimulating consumption, income and
employment.
7. Taxes: If government takes away the newly generated income in
the form of taxes, the value of multiplier will fall.
8. Corporate Savings: The part of net profit not distributed as
dividends and retained by the business for expansion, will also

13.  Limitations Of The Theory Of Multiplier
1. It is a static theory as MPC decreases with the increase in income and
therefore, multiplier cannot be constant.
2. As the behaviors of the people may change, it is difficult to project the
expected consumption using past records. So, it is difficult to calculate
aggregate marginal propensity to consume.
3. Multiplier shows the process of income generation from one point of
equilibrium to another, but it fails to analyze the actual sequence of events
that increases the level of income.
4. The theory is unable to explain the effects of change in income and
consumption on investment.
5. Investment multiplier do not take in to consideration the effects of derived
demand. It just takes into account the induced demand of consumption
goods.
6. Ignorance of time element in the generation of income.
7. Even the use of investment and production of goods and services for the
increased demand requires time and during this gap, multiplier effect is

14. 8. If the economy operates under the situation of full employment,
the multiplier concept will not be applicable as it can have the
shown impact in the situation of involuntary unemployment.
9. It is difficult to know the size of additional investment, as
increased investment in public sector reduces the investment in
private sector.
10.The under developed countries are having the problem of
increasing their productive capacity as they are having scarcity of
factors of production. The theory of multiplier works when the
country is having excess production capacity, therefore, this theory
is not applicable for under developed economies.
11.No empirical evidences.

15. ACCELERATION PRINCIPLE
Meaning:
The acceleration principle shows how changes in demand for
consumption goods affect the demand for capital goods. It expresses
the ratio of the net change in consumption to the net change in
investment. It measures the changes in the capital goods industries
consequent upon the changes in customer goods industries.
The principle of acceleration states that a given increase in the
demand for consumer goods leads to an accelerated demand foe
investment goods.
it can be expressed as
a = ΔI/ΔC
where, a stands for acceleration coefficient, ΔI is net change in
investment outlay and ΔC is net change in consumption outlay.
If the net change in consumption outlay of k20 crores leads to a net increase
in investment outlay of k40 cores then the acceleration coefficient will be 2.

16. FUNCTIONING OF THE ACCELERATION
PRINCIPLE
Suppose the existing demand for consumption goods in the
economy is 1000 units per year.
The capital output ratio is 1:10, that is 100 units of capital
goods are required to maintain a constant flow of 1000 units of
consumption goods.
If each of the capital goods is having a life span of 10 years, so
100 units of capital goods will wear out in 10 years therefore
we need 10 machines every year by the way of replacement, so
that 100 machines are kept in fact at the end of tenth year.
This demand for 10 machines every year is known as
replacement demand.
The acceleration coefficient is one.

17. Now suppose that the demand for consumer goods increase by 10%
next year. This means the demand for consumer goods will increase
from 1000 units to 1100 units.
To produce this additional 100 units of consumption goods we
require additional 10 units of capital goods or machine as we have
assumed the capital output ratio of 1:10.
This is of course in addition to the 10 units of capital goods which
are required every year for replacement purposes.
Thus, the total demand for new capital goods will be
i. 10 units of capital goods for replacement.
ii. 10 units of capital goods to satisfy the increased demand for
consumption goods.
 Here, only 10 % of increased demand for consumption goods leads
to 100% increase in demand for capital goods(10 units to 20 units).
Here the acceleration will be 10.
 A small increase in consumption demand leads to a huge increase
in the demand for capital goods.

18.  It cam be seen from the above table that a cooperatively small rise of
10% in the demand for consumption goods cause a rise of 100%
increase in the demand for capital goods.
The acceleration principle shows that, a small change in
consumption leads to a huge change in induced investment.
Year Consumpti
on demand
Total
requireme
nt of
capital
goods
Replaceme
nt demand
New
demand
for
capital
goods
Total
demand
for
capital
goods
Percentag
e change
1st year 1000 units 100 units 10 units - 10 units -
2nd
year
1100 units 110 units 10 units 10 units 20 units 100 %

19. LIMITATIONS OF ACCELERATION
PRINCIPLE1. Unrealistic assumption of constant capital output ratio. This is perhaps
not possible because of inventions and technological progress. Arrival
of new and better technology will increase the output per unit of
capital.
2. There should not be surplus capacity in the capital goods industries, or
else the increase in the demand for consumption goods may be met by
the better utilization of existing capital equipment rather than by fresh
investment.
3. The entrepreneurs will not increase the investment if they feel that the
increase in the demand for consumption goods are of temporary
nature.
4. If the human and materials required to produce the capital goods are
not adequately available, as if the economy is working in the near
situation of full employment, the acceleration principle may not prove
to be correct.

20. 6. In several cases where investment decisions do not await for the
changes in the rate of consumption. This can be in the case of
public sector enterprises where long term investments are made
well in advance of expected change in the level of consumption.
7. According to Semuelson, for a study of the complete analysis of
the process of income generation, we must consider both the
multiplier effect as well as the acceleration effect.

21. THANK YOU