The Marginal Propensity to Consume and the Multiplier

The net increment of investment can manifest as increased public works if we assume that there is:

• no offset through decreased investment in other directions
• no associated change in the propensity of the community to consume

Mr. Kahn was mainly concerned in the article referred to in the previous section:

• in considering what offsets we should take into account as likely to be important, and
• in suggesting quantitative estimates.

Aside from a specific increase of investment leading to the final result, there are several other factors.

If, for example, a Government employs 100,000 additional men on public works, and if the multiplier (as defined above) is 4, we cannot safely assume that aggregate employment will increase by 400,000.

• This is because the new policy might have adverse reactions on investment in other directions.

The following are the factors which we should not overlook. The first two will be fully intelligible in Book 4:

1. The method of financing the policy and the increased working cash, required by- the increased employment and the associated rise of prices, might increase the interest rate.

If it does, then it retards investment in other directions, unless the central bank takes steps to the contrary.

At the same time, the increased cost of capital goods will reduce their marginal efficiency to the private investor.

This will require an actual fall in the rate of interest to offset it.

2. With the confused psychology which often prevails, the Government programme may, through its effect on “confidence”, increase the love for cash or reduce the marginal efficiency of capital.

These may also retard other investment unless measures are taken to offset it.

3. In foreign-trade, some part of the multiplier of the increased investment will accrue to the benefit of employment in foreign countries, since a proportion of the increased consumption will diminish our own country’s favourable foreign balance;

so that, if we consider only the effect on domestic employment as distinct from world employment, we must diminish the full figure of the multiplier. On the other hand our own country may recover a portion of this leakage through favourable repercussions due to the action of the multiplier in the foreign country in increasing its economic activity.

Furthermore, if we are considering changes of a substantial amount, we have to allow for a progressive change in the marginal propensity to consume, as the position of the margin is gradually shifted; and hence in the multiplier. The marginal propensity to consume is not constant for all levels of employment, and it is probable that there will be, as a rule, a tendency for it to diminish as employment increases; when real income increases, that is to say, the community will wish to consume a gradually diminishing proportion of it.

There are also other factors, over and above the operation of the general rule just mentioned, which may operate to modify the marginal propensity to consume, and hence the multiplier; and these other factors seem likely, as a rule, to accentuate the tendency of the general rule rather than to offset it. For, in the first place, the increase of employment will tend, owing to the effect of diminishing-returns in the short period, to increase the proportion of aggregate income which accrues to the entrepreneurs, whose individual marginal propensity to consume is probably less than the average for the community as a whole.

In the second place, unemployment is likely to be associated with negative saving in certain quarters, private or public, because the unemployed may be living either on the savings of themselves and their friends or on public relief which is partly financed out of loans; with the result that re-employment will gradually diminish these particular acts of negative saving and reduce, therefore, the marginal propensity to consume more rapidly than would have occurred from an equal increase in the community’s real income accruing in different circumstances.

In any case, the multiplier is likely to be greater for a small net increment of investment than for a large increment.

Where there are substantial changes, we must be guided by the average value of the multiplier based on the average marginal propensity to consume over the range in question.

Mr. Kahn has examined the probable quantitative result of such factors as these in certain hypothetical special cases.

But, clearly, it is not possible to carry any generalisation very far.

One can only say, for example, that a typical modern community would probably tend to consume not much less than 8o% of any increment of real income, if it were a closed system with the consumption of the unemployed paid for by transfers from the consumption of other consumers, so that the multiplier after allowing for offsets would not be much less than 5.

The multiplier may fall as low as 2 or 3 times the employment provided by a new investment if the country:

• has foreign trade that accounts for 20% of consumption
• has the unemployed receive out of loans or their equivalent up to 50% of their normal consumption when in work

Thus a given fluctuation of investment will be associated with a much less violent fluctuation of employment in a country in which foreign trade plays a large part and unemployment relief is financed on a larger scale out of borrowing (as was the case, eg., in Great Britain in 1931), than in a country in which these factors are less important (as in the United States in 1932).[5]

Fluctuations in the amount of investment are a comparatively small part of the national income.

• These can cause fluctuations in aggregate employment and income that are much greater in amplitude than those original fluctuations in investment.
• The multiplier’s general principle can help answer how this fluctuation does so.