Keynes' Theory of Investment and the Multiplier Effect, and Ricardian Theory of Comparative Advantage

This article explains Keynes' Theory of Investment and the Multiplier Effect, and Ricardian Theory of Comparative Advantage. Keynes' theory explains how investment gets a boost when interest rates are low and how the multiplier effect causes the economy to grow further. Ricardian theory suggests that every country should export the product in which it has a comparative advantage. The article provides examples and assumptions to explain both theories.

Question 1: Theory of Investment by Keynes
Keynes gave “The General Theory of Employment, Interest and Money” explaining the
dynamic between the three factors: employment, interest rates and money. In these, Keynes
explained how investment gets a boost when the interest rates are low. Low interest rates,
induce consumers to spend more (in turn, boosting investment) and producers to invest more.
Keynes also, gave an understanding of the multiplier effect which causes the economy to
grow further, once the economy achieves an expansionary trajectory.(Samuelson &
Nordhaus, 2010) A general depiction of this model is given below:
Illustration 2 : The Investment Multiplier Model. Source: (Samuelson & Nordhaus, 2010)
In Panel A, as the Reserve Bank of Australia reduces the cash rate, for example from
2% to 1.5 %. This leads to an increase in money supply from SA to SB within the
economy. Money supply increases because it is a lot more profitable for producers and
consumers to hold in hand cash balances rather than make bank deposits.
In Panel B, the impact of reduction in interest rate is depicted, given that lower interest
rates would be an incentive for producers to borrow money, as credit would be easy to
come by. Assuming investment was at an index of 100 and would now shift to, an

index of 200. This investment would, to some extent, result in an expansion of
production capacity.
In Panel C, as production capacity increases, the general level of output and
employment may increase too. This is economic expansion. (Samuelson & Nordhaus,
2010)
Multiplier Effect
According to Keynes, the increase of money supply does not have just a direct effect, rather
an “ accelerating effect” i.e. investment begets higher output which in turn leads to greater
money supply leading, again to more investment. Hence, there is a multiplier effect.
(Samuelson & Nordhaus, 2010)
This theory has its shortcomings as it only takes a monetary view of the economy and does
not address structural issues or “real” economy.
Question 2 Theory of Comparative Advantage
The Theory of Comparative advantage was given by David Ricardo and is also known as
“Ricardian Theory of Comparative Advantage”. The Theory suggests that every country
should export that product in the production of which, it has a comparative advantage in.
(Kılı, 2002). According to the Theory, even if a country has a comparative advantage, it
should still get involved in Free Trade as by doing so, it can focus on production of the
product that it is best suited to produce.
According to Ricardian Theory postulates, (Kılı, 2002)
Total Output= Marginal Productivity of Labour X Total Number of workers
For example, the two countries Australia and New Zealand, country that produce both grapes
and corn. The price for both goods are given in the table 1. The Marginal Productivity of
Labour, or the number of units (kilos) of product produced per unit of labour per hour, is
given in Table 2
Assumptions:
● Each country produces only the two goods: Corn and Grapes
● The labour force (number of labourers) in both countries is the same
● Both countries are in autarky(i.e. Economically self sufficient)
● There is a no other form of international trade
● There is only one factor of production i.e. labour
(Feenstra, 2015)
Table 1: Marginal Productivity in Australia and New Zealand
Corn Grapes

Australia 1.25 1
New Zealand 2 2
Each of these countries will export the good that it has “comparative advantage” in. In this
example, comparative advantage can be gained only from the marginal productivity. Hence,
the price of both products in both the countries (hypothetically) is:
Table 1 Price of Corn and Grapes in both countries (AUD per Kilo)
Corn Grapes
Australia 3 6
New Zealand 6 3
In this example, it also follows, that the price of a product will be lower in the country for the
product that which it has higher marginal productivity in. Hence, it should export that
product.
Australia is better off with trade, even when the Marginal Productivity of Labour of Australia
for both products is higher. According to the Ricardian theory, even when a country gets
better terms of trade in both the products it produces, it must specialize in the production of
the product that it has an advantage in (in this case, the product that it has a higher Marginal
Productivity of Labour in). In doing so, each country shall be able to maximize the efficiency
of allocation of factors of production.(Feenstra,2015) Hence, both countries shall profit from
indulging in Free Trade.
References:
Feenstra, R. C. (2015). Advanced International Trade Theory and Evidence: Second Edition.
Princeton, New Jersey: Princeton University Press.

Kili¸c, R. (2002). University of Michigan. Retrieved August 23, 2018, from Absolute and
Comparative Advantage: Ricardian Model: www.msu.edu
Samuelson, P., & Nordhaus, W. (2004). Economics: Seventeenth edition. New Delhi: Tata
McGraw Hill.