The Keynesian Multiplier helps one understand the process of creation of wealth in a nation. When one rupee is earned in a country, that implies that the GDP of the country rises by more than one rupee through the multiplier effect.
Let’s work through a hypothetical example: A factory is setup in a town with a payroll of INR 1,00,000. Assuming that the 1 lakh mentioned above is the only expenditure the factory undertakes in that town and each citizen of that town spends exactly 75% of his income. How much would we expect the income of the town to rise by?
The 1 lakh would be an addition to the town’s income. However, the INR 75,000 spent by the workers additionally will become income for the shopkeepers, plumbers, lawyers, teachers, etc. Thus the town’s income will rise by at least INR 1,75,000. But the story does not end here. The shopkeepers, plumbers, etc. who received the INR 75,000 will in turn spend 75% of their income locally, and this INR 56,250 will become income for other people in the community. Total income of the town is now INR 2,31,250.
The process will continue on and on, and as it does, total income will approach INR 4 lakh. This has been been derived through a simple geometric progression, the answer to which is 1 lakh/(1-0.75)
The Keynesian multiplier applies to a country’s economy in a similar fashion. The major assumptions of this model are how people spend. This concept is exceptionally important because it implies that if the government pumps in fiscal stimulus worth INR 50 crore through NREGA or road building activities, that helps in improving the country’s GDP by more than 50 crore, as a portion of this earning of 50 crore is further spent on other commodities.