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Keynes Multiplier Effect:

Two aspects of Keynes' model had implications for policy: First, there is the "Keynesian multiplier", Exogenous increases in spending, such as an increase in government outlays, increases total spending by a multiple of that increase. A government could stimulate a great deal of new production with a modest outlay if: 1. 2. The people who receive this money then spend most This extra spending allows businesses to hire more

on consumption goods and save the rest. people and pay them, which in turn allows a further increase consumer spending. This process continues. At each step, the increase in spending is smaller than in the previous step, so that the multiplier process tapers off and allows the attainment of equilibrium. This story is modified and moderated if we move beyond a "closed economy" and bring in the role of taxation: the rise in imports and tax payments at each step reduces the amount of induced consumer spending and the size of the multiplier effect.

For Example:
Suppose a factory with a payroll of $500,000 locates in a Lemmingville, a typical suburban community. Suppose further that the $500,000 is the only money that the factory spends in the community, that all employees live in Lemmingville, and that each person who lives there spends exactly one half of his income locally. By how much will the income of Lemmingville rise as a result of the new factory? The $500,000 will be an addition to Lemmingville income. But the story does not end here because, by assumption, the people who earn the payroll will spend one half of the payroll, or $250,000, in the community. This $250,000 will become income for the shopkeepers, plumbers, lawyers, teachers, etc. Thus Lemmingville income will rise by at least $750,000. But the story does not end here either. The shopkeepers, plumbers, etc. who received the $250,000 will in turn spend one half of their new income locally, and this $125,000 will become income for other people in the community. Total Lemmingville income is now $875,000. The process will continue on and on, and as it does, total income will approach $1,000,000. Notice that the initial half million in income expands to one million once in the system. There is a multiplier effect that is similar to the multiplier effect in the model of contingent behavior. The size of the multiplier in our suburb depends on the percentage of income people spend within the

community. The smaller the percentage, the more quickly the extra income leaks out of the economy and the smaller the multiplier. The Keynesian multiplier model applies to the national economy the logic by which a new factory can increase a town's income by a multiple of its payroll. Central in this model is an assumption about how people spend the consumption function. The consumption function says that the amount people spend depends on their income, and that as income increases, so does consumption.

By: Abhishek Mishra ISBE-A//SS//10-12 IIPM, Ahmedabad