Limitations of the Multiplier Concept
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Limitations of the Multiplier Concept

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:

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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