Monday, 8 July 2013

leakages from multiplier,Importance and limitations

Leakages of multiplier

Leakages of multiplier
The incomes of people are influenced by various factors limiting the process of multiplier. That is, due to leakages in income flow the effect of multiplier is reduced. If the marginal propensity to consume is 50% than 50% of increased income is taken as the leakages and only 50% is used in consumption expenditure. Due to the leakages the national income does not increase fully. So, leakages in various forms are the leakages of multiplier. Main leakages of multiplier are as follows:
1. Saving
Saving is one of the most important leakages of the multiplier because whole part of the increment in income is not used in consumption since marginal propensity to consume is less than unity in other words, some parts of the income is saved and this will remain separate from the income flow that will occur later on. Therefore, the higher, the marginal propensity to save in the economy, the smaller is the size of the multiplier. Similarly, the lower the marginal propensity to save, the larger is the size of the multiplier.
2. Debt cancellation
If part of the increased income is used to pay back the loan, then that part of the income won’t have any kind of effect on consumption and this will check the process of the multiplier. As a result, the size of the multiplier will be small.
3. Net imports
If part of the increased income is used on the consumption of foreign goods, then this won’t have any kind of effect on the consumption of the national production. That is, the expenditure on imported goods is the loss to the country. This will decrease the value of the multiplier.
4. Inflation
If due to increased investment the inflation increases then most part of the increased income will be used to pay for the increased price. This will affect the multiplier. That is, increase in the price of the consumption goods of the consumer’s means the expenditure on those goods will increase. Increase in the price of goods decreases the real consumption of the people. Thus, inflation is also one of the main leakages of multiplier.
5. Purchase of old stock and securities
If some part of the increased income is used in the purchase of old stock and securities in addition to consumption goods, then cumulative effect of income will be less than before. As people start purchasing old stock and securities, the consumption expenditure decreases and the size of the multiplier will be small.

Importance or uses of multiplier

Concept of multiplier is important form the theoretical as well as practical point of view. For this reason, the importance of multiplier in business and economic sector. The importance of the multiplier can be explained as follows:
1. Importance in investment
Multiplier theory has taken investment as the important factor of the economy. The proportionate increase in the level of income and employment in the economy depends up on the multiplier. This clarifies that increase in income and employment is on the basis of increase in investment.
2. Analysis of trade cycle
It is easier to analyses trade cycle on the basis of multiplier. Multiplier helps in estimating the increase in income as a result of increase in investment. So, multiplier will be of great importance in formulating progressive policies to bring the effects in the economy to right speed.
3. Formulation of economic policy
The main objective of every economic policy is to create the situation of full employment in the economic. Therefore policy makers will formulate their country’s economic policy using the multiplier. This will help in creating the situation of full employment.
4. Public investment
Public investment is of great importance specially in the situation of depression and unemployment, because this does not stress much on profits. Multiplier indicates the importance of public investment in increasing the level of employment.
5. Equality between saving and investment
The equality between saving and investment can be brought about with the help of multiplier. Increase in investment increases the income. Increase in income will bring about equality in saving and investment.


Concept of multiplier is important form the theoretical as well as practical point of view. For this reason, the importance of multiplier in business and economic sector. The importance of the multiplier can be explained as follows:
1. Importance in investment
Multiplier theory has taken investment as the important factor of the economy. The proportionate increase in the level of income and employment in the economy depends up on the multiplier. This clarifies that increase in income and employment is on the basis of increase in investment.
2. Analysis of trade cycle
It is easier to analyses trade cycle on the basis of multiplier. Multiplier helps in estimating the increase in income as a result of increase in investment. So, multiplier will be of great importance in formulating progressive policies to bring the effects in the economy to right speed.
3. Formulation of economic policy
The main objective of every economic policy is to create the situation of full employment in the economic. Therefore policy makers will formulate their country’s economic policy using the multiplier. This will help in creating the situation of full employment.
4. Public investment
Public investment is of great importance specially in the situation of depression and unemployment, because this does not stress much on profits. Multiplier indicates the importance of public investment in increasing the level of employment.
5. Equality between saving and investment
The equality between saving and investment can be brought about with the help of multiplier. Increase in investment increases the income. Increase in income will bring about equality in saving and investment.



Limitations of the Multiplier Concept The working of the multiplier, as demonstrated above, actually represents an ideal. It contains several qualifications, which may not be found in practice. The factors which operate to reduce the multiplying effect are technically called "Leakages". The various limitations to the full working of the multiplier in this regard are as follows:
1. MPC Not Constant. Keynes's concept of multiplier effect is based on the marginal propensity to consume assumed to be constant, so that the marginal propensity to save will necessarily be constant. Hence, Keynes ruled out the possibility of leakages. But in a dynamic economy, the
MPC, or inversely the marginal propensity to save, is never constant. In fact, as income increases, the marginal propensity to save is likely to rise and, therefore, the value of the multiplier is likely to fall.
Thus, in practice, there is nothing stable about the value of the multiplier effect as Keynes assumed.

2. Debt Cancellation. If people use a part of new increment in income to repay their old debts instead of spending it on further consumption that part of income disappears from the income stream.

3. Hoarding of Cash Balance. If people prefer to hold cash balances in the form of inactive bank deposits with a strong liquidity preference to satisfy transaction, precautionary and speculative motives, that will provide a source of leakage from the income stream.


4. Purchase of Old Stocks and Securities. If a part of the newly-created income is spent on buying old stocks, shares and securities or on other financial investments, consumption will be less and the corresponding multiplier will be low.

5. Net Imports. A leakage in the domestic income stream also occurs when there is excess of imports over exports, causing a net outflow of funds to foreign countries.

6. Price Inflation. When there is a rise in the price 
of consumption goods, a good part of the increased money expenditure out of the increased income will be degenerate on higher prices instead of encouraging expenditure, revenue and employment. Thus, the amount of added purchasing power which is absorbed in the increasing prices may be considered as a leakage.

7. No Net Investment. Furthermore, the multiplier effect refers to changes in income due to changes in investment. But this 'changes in investment' should refer to the net investment, for otherwise an increase in investment in one sector may be offset by a decline in investment in another sector and the flow of income stream may remain unchanged and the multiplier effect may not materialize.

8. Beyond Full-employment Ceiling. Finally, it should be noted that the multiplier effect cannot operate in propagating higher income after the full employment ceding is reached after which a steady increase in investment expenditure will be dissipated in higher prices, i.e., in price inflation.
Thus, it may be said that the actual multiplier will be different from the ideal which is based on certain assumptions that may not hold good in practice.

Importance
In spite of the above limitations, the multiplier principle occupies a very important place not only in economic theory but also in shaping economic policy. It plays a vital role as an instrument of income building. It tells us how a small increase in investment can result in large increase in income. It is of special importance in the study and control of business cycles. It furnishes guidelines for appropriate income and employment policies. It also explains the expansion of public sector in modern times.



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