Multiplier in an Underdeveloped Economy – Explained!

Read this article to learn about the multiplier in an underdeveloped economy.

Multiplier is an important tool of analysis in Keynesian economics. It is the basis of the theory of income generation and the mechanism through which income gets propagated.

Multiplier is the ratio between an initial increment in investment and the final increment in income. The higher the margin propensity to consume, the higher the value of multiplier. It works vigorously in the earlier stages in the cycle, when the economy shows an upward trend and life MPC is high. Thus, in advanced economies, multiplier has been given a key role in the process of revival and then as the main engine that lifts the economy out of depression and places it on the threshold of full employment.

Once the existing capacity is fully utilized, the multiplier works in combination with the accelerator to utilize all the available real resources. From this, one may presume that since MPC is very high in underdeveloped economies, a Small initial investment will result in a much higher increase in income. But the proem of income multiplication does not work so smoothly in an underdeveloped economy. This is because the main instrument, the multiplier, does not work in the simple fashion visualized by Keynes, primarily for the industrial economies.

For an efficient working of the multiplier, the Keynesian assumptions—of involuntary unemployment, of excess capacity, of elastic supply of labour and capital—must be fulfilled. These conditions are obtained in advanced economies only. In an underdeveloped economy a large part of the unemployed labour force is found in the agricultural sector, which is unskilled. Labourers are tied to their family farms and seem to enjoy a real income which gives them probably the same satisfaction as they would get when fully employed.

This type of disguised unemployment can hardly be called involuntary and cannot be removed through employment at the current wage rate. Therefore, higher wages along with other incentives are needed to remove them from their farms. In other words, it means that more output obtained only at a high cost. To the extent additional labour is not available at the current money wage rate, increases in employment cannot follow from an initial increase in investment and to that extent the absence of involuntary unemployment reduces the magnitude of multiplier in underdeveloped economies.

In an underdeveloped economy, the secondary and tertiary effects on income output and employment do not follow as a result of an initial increase in investment, even though the MPC is very high. Whenever additional investment is made, it leads to a rise in the demand for food and cheap industrial consumer goods amongst the working force and to increased demand of luxury imports amongst the ‘rich classes. Agricultural output is inelastic, as least in the short period, whatever little increase in output takes place, it is consumed on the farm itself and is not brought to the market.

Thus, an increase in investment increases income of the farmers in the primary sector in the first round and not in secondary and tertiary sector. Increased investment expenditures result in a contraction of the marketable surplus of the most essential consumables and generate a price spiral. Money incomes may multiply but real incomes do not increase much. The real income multiplier turns into a price multiplier. Therefore, “the income multiplier is much higher is money terms than in real terms, and to that extent prices rise much faster than an increase in aggregate real income the multiplier principle, therefore, works with reference to money income but not with reference to real income of employment.”

The line of argument presented above is quite convincing and does corroborate at least Indian experience during the last 20 years. However, it does not mean that the concept of multiplier itself is useless. Contemporary literature on growth economies has made use of many variants of the concept. If we take the case of developing economies, in the long run setting, much of the criticism of the concept seems misplaced. The critics have viewed the operation of the multiplier process in a completely static setting and as a purely short period concept, whereas the very rationale of economic development is long-run dynamic change.

When we take into account longer periods of time, the capacity creating aspect of investment also becomes relevant. The operation of multiplier is only subject to a lag varying from industry to industry. The wider the range of industries over which investment is undertaken, the more pronounced will be the multiplier effect, for the rounds of expenditures emanating from investment in any one industry could draw upon the output capacity created in a variety of industries.

Multiplier operates in economies where the rate of growth is fast enough to generate capacity at the rate at which demand increases. These economies are developing economies in a state of transition. Here the supply of consumer goods (food, textiles, or small industry consumer goods) is not inelastic as is generally assumed. Rather, immediate production potential lies in this very sector and hence multiplier process will operate.

The multiplying demand has some acceleration effects also, both in the backward and forward direction, called ‘linkage effects’. In fact, the whole process of development has to be viewed as an interaction of one type of investment on another type of investment and of investment on national income, with the result that in a developing economy the ultimate multiplicative effect of an initial act of investment on real output would be far higher than the original outlay on investment itself.